High risk high jinks and the regulators

Business owners, be outraged. Next time you go to get credit you could well be told you are too high risk. COLIN BENJAMIN

Colin Benjamin

By Colin Benjamin

Business owners, be outraged. Next time you go to get credit you could well be told you are too high risk.

But guess what is also high risk? Changing the regulations, which would prevent racketeers commanding massive salaries and contributing to a credit crunch.

It is increasingly looking like a change in regulations is not going to happen.

The banks are arguing that because they are international they are not accountable to any jurisdiction.

In the US, the SEC is exploring permitting US firms to use escape hatch accounting practices from anywhere around the world rather than go back to the standards that were introduced a decade ago with the collapse of Long Term Capital Management (LTCM).

But we have been through all this before. In April 1999 Robert Rubin (treasury secretary), Alan Greenspan (Fed chairman), Arthur Levitt, (SEC chairman) and Brooksley Born (chairperson of the Commodity Futures Trading Commission) reported in a 180-plus page report entitled “Hedge Funds, Leverage and the Lessons of Long-Term Capital Management”. It included:

The principal policy issue arising out of the events surrounding the near collapse of LTCM is how to constrain excessive leverage. By increasing the chance that problems at one financial institution could be transmitted to other institutions, excessive leverage can increase the likelihood of a general breakdown in the functioning of financial markets. This issue is not limited to hedge funds; other financial institutions are often larger and more highly leveraged than most hedge funds.

However the hedge funds are pushing back against any substantive measures to introduce the triple-T standards of truth, trust and transparency to their operation.

Already we have Robert Steel, the US Treasury’s top financial official meeting with Bernanke to argue against stricter regulation of hedge funds because it would increase risks by suggesting that the government has given their investments an “all-clear”. Steel says it would be costly and impossible to train enough people to keep tabs on some 8000 hedge funds

The actions of the central banks to socialise failing banks (Northern Rock in the UK) and pump short term funds into financial investment houses is seen as propping up the US banking system.

Steel told the Manhattan Institute yesterday: “I don’t like the moral hazard of communicating a government “all-clear”. The risk is that regulation communicates confidence in a product that is riskier than normal investors should get involved in.”

Even George Soros who made a cool $USbillion with his Quantum Fund, betting against the British pound, concedes that the International Monetary Fund estimate of a $US1 trillion in global losses is not only a fair estimate, but is likely to grow. He blames the lack of transparency in the credit default market, which he calculates at $US45 trillion, as the root of the growing worldwide credit crunch.

Soros takes a more realistic view of the financial crisis that has only reached a half-time hold up while banks begin to admit that liquidity issues are the least to their concerns. The housing price bubble has been pricked around the world and investors face the “worst financial crisis of our lifetime”.

The interesting questions about “moral hazard” and continuing support for the opaque and turgid money machines that can just start new hedge funds while freezing the funds of current “losers” shows that the bankers are still more concerned with leveraging “OPM” than making any real attempt at the triple-T standard.

All those people seeking funds for genuine enterprises that actually produce something of value should push for the introduction of the solutions proposed by the President’s Working Group on Financial Markets a decade ago.

They concluded: “In view of our findings, the Working Group recommends a number of measures designed to constrain excessive leverage. These measures are designed to improve transparency in the system, enhance private sector risk management practices, develop more risk-sensitive approaches to capital adequacy, support financial contract netting in the event of bankruptcy and encourage off-shore financial centres to comply with international standards.”

Lest it be felt that pushing this agenda might be a bit radical and actually change the future for our financial institutions, just go back to Bernanke’s speech in May 2006 on hedge funds and systemic risk to the Reserve Bank of Atlanta where he said: “If leveraged investors default while holding positions that are large relative to the markets in which they have invested, the forced liquidation of those positions, possibly at fire-sale prices, could cause heavy losses to counterparties. These direct losses are of concern, of course, particularly if they lead to further defaults or threaten systemically important institutions; but, in addition, market participants that were not creditors or counterparties of the defaulting firm might be affected indirectly through asset price adjustments, liquidity strains, and increased market uncertainty.”

“The primary mechanism for regulating excessive leverage and other aspects of risk-taking in a market economy is the discipline provided by creditors, counterparties, and investors. In the LTCM episode, unfortunately, market discipline broke down. LTCM received generous terms from the banks and broker-dealers that provided credit and served as counterparties, even though LTCM took exceptional risks. Investors, perhaps awed by the reputations of LTCM’s principals, did not ask sufficiently tough questions about the risks that were being taken to generate the high returns.”

In the words of that song… “When will they ever learn?”


Dr Colin Benjamin is Entrepreneurship and Strategic Thinking Consultant at Marshall Place Associates, which offers a range of strategic thinking tools that open up possibilities for individuals and organisations committed to applying the processes of innovation, creativity and entrepreneurship. Contact: CEO Dr Jane Shelton.

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