Running out of credit
Pro-cyclical accounting standards and the Basel II prudential requirements have amplified the impact of the crisis by starving the economy of the oxygen it needs to survive.
ANZ's retiring deputy chief executive, Bob Edgar doesn't appear to be much of a fan of mark-to-market accounting or of the pro-cyclical impact of the Basel II prudential regime, both of which he sees as contributing to the depth of the crisis in the global financial system and complicating the ability of the banking system to cope with the implosion of the shadow banking system.
A year ago Edgar told a Minter Ellison forum that the US market for securitised debt was roughly equivalent to the size of the official banking system and argued that there wasn't sufficient capital available for the banking system to replace the role that securitised debt markets had played in funding corporate activity and in allowing the banks themselves to churn their own capital (Importing the credit crunch, February 12 2008).
Today, at a similar forum organised by the law firm, he revisited the subject. In the Great Depression, he said, about half of the 15,000-plus banks in the US collapsed, causing an enormous contraction in the capacity of the banking system to supply credit. That puts the current crisis into perspective.
If the shadow banking system involved, not just securitised debt but private equity, mortgage funds, derivatives and direct intermediation between corporates and markets, the US financial system was more than twice the size of its official banking system. In Australia the shadow system was about half the banking system.
In the US, and in Europe, the banking systems have been shrinking because of the holes in bank balance sheets caused by the banks' interaction with the shadow banking system, despite the massive infusions of taxpayer-funded capital.
The combination of the relative sizes of the official and unofficial banking systems and the problems the banks themselves have incurred underscores the daunting depth of the challenge facing the US and some European governments and regulators.
In the Great Depression the surviving half of the banking system couldn't expand sufficiently to replace the half that disappeared. In the current crisis it isn't feasible that the official banking system, afflicted as it is with its own sub-prime wounds, can fill in the holes in the shadow system.
In Australia, credit has actually been growing, with the major banks expanding their lending. Growth has, however, been quite modest (5.5 per cent to the end of February) relative to recent double-digit norms because the banks haven't been able to, or perhaps haven't wanted to, expand their balance sheets fast enough to fully compensate for the contraction in lending by other banks and non-banks and the effective closure of the securitised debt markets.
Edgar, who retires after 25 years with the bank at the end of next month, said, for that where once there were more than 20 foreign banks active in this market there are now only five or six. As syndications organised in different times come up for refinancing the foreign banks are withdrawing or at least scaling down their Australian exposures.
While Edgar didn't say it, that is the premise that under-pins the creation of the Australian Business Investment Partnership, or RuddBank, which the Federal Opposition is opposing. The politics of banks that have been partly nationalised in order to help maintain lending in their home markets using that taxpayer capital to lend to Australian borrowers argue strongly for a large-scale withdrawal of the foreign banks over time.
The normal capacity constraints for the four majors – their own constrained access to capital and the need to provide against the rising levels of non-performing debts as the economy slides into recession – have been exacerbated by accounting and capital adequacy regimes.
The mark-to-market regime creates losses, and reduces capital levels, for assets held in the banks' trading books while it is now well-recognised that the combination of the accounting regime and the well-intentioned Basel II prudential requirements have exacerbated the crisis by creating pro-cyclical outcomes.
Edgar provided a nice illustration. The Australia banking system has risk-weighted assets, he said, of about $1.372 trillion and has capital held against those assets of about $105 billion.
If there were a one percentage point change in the risk-weightings – and the banks are required to recognise and respond to shifts in the risk environment – the risk-weighted assets would be recalculated and reduced to $987 billion. If the banks also had to increase write-offs for loan losses by one percentage point, risk-weighted assets would fall to $893 billion and the bank's capital bases would be restated at $95 billion.
In an environment where banks are also now required to use discounted cash flow valuations to bring forward the value of interest foregone over the life of a non-accrual loan (rather than recognising the loss of income within the accounting period) relatively small changes in accounting treatments or prudential settings can have major impacts on their balance sheets – and on their capacity to lend.
International legislators and regulators have belatedly recognised the role that the international accounting standards and Basel II have played in amplifying the impact of the crisis. The system will eventually produce more prudent counter-cyclical provisioning and accounting treatments that better reflect hold-to-maturity values for financial assets.
In the meantime, the pro-cyclical squeeze on bank balance sheets and their capacity to lend – coupled with their own increased risk-aversion – isn't conducive to maximising levels of economic activity or insulating this system from the after-shocks still rumbling through systems offshore.
A year ago Edgar told a Minter Ellison forum that the US market for securitised debt was roughly equivalent to the size of the official banking system and argued that there wasn't sufficient capital available for the banking system to replace the role that securitised debt markets had played in funding corporate activity and in allowing the banks themselves to churn their own capital (Importing the credit crunch, February 12 2008).
Today, at a similar forum organised by the law firm, he revisited the subject. In the Great Depression, he said, about half of the 15,000-plus banks in the US collapsed, causing an enormous contraction in the capacity of the banking system to supply credit. That puts the current crisis into perspective.
If the shadow banking system involved, not just securitised debt but private equity, mortgage funds, derivatives and direct intermediation between corporates and markets, the US financial system was more than twice the size of its official banking system. In Australia the shadow system was about half the banking system.
In the US, and in Europe, the banking systems have been shrinking because of the holes in bank balance sheets caused by the banks' interaction with the shadow banking system, despite the massive infusions of taxpayer-funded capital.
The combination of the relative sizes of the official and unofficial banking systems and the problems the banks themselves have incurred underscores the daunting depth of the challenge facing the US and some European governments and regulators.
In the Great Depression the surviving half of the banking system couldn't expand sufficiently to replace the half that disappeared. In the current crisis it isn't feasible that the official banking system, afflicted as it is with its own sub-prime wounds, can fill in the holes in the shadow system.
In Australia, credit has actually been growing, with the major banks expanding their lending. Growth has, however, been quite modest (5.5 per cent to the end of February) relative to recent double-digit norms because the banks haven't been able to, or perhaps haven't wanted to, expand their balance sheets fast enough to fully compensate for the contraction in lending by other banks and non-banks and the effective closure of the securitised debt markets.
Edgar, who retires after 25 years with the bank at the end of next month, said, for that where once there were more than 20 foreign banks active in this market there are now only five or six. As syndications organised in different times come up for refinancing the foreign banks are withdrawing or at least scaling down their Australian exposures.
While Edgar didn't say it, that is the premise that under-pins the creation of the Australian Business Investment Partnership, or RuddBank, which the Federal Opposition is opposing. The politics of banks that have been partly nationalised in order to help maintain lending in their home markets using that taxpayer capital to lend to Australian borrowers argue strongly for a large-scale withdrawal of the foreign banks over time.
The normal capacity constraints for the four majors – their own constrained access to capital and the need to provide against the rising levels of non-performing debts as the economy slides into recession – have been exacerbated by accounting and capital adequacy regimes.
The mark-to-market regime creates losses, and reduces capital levels, for assets held in the banks' trading books while it is now well-recognised that the combination of the accounting regime and the well-intentioned Basel II prudential requirements have exacerbated the crisis by creating pro-cyclical outcomes.
Edgar provided a nice illustration. The Australia banking system has risk-weighted assets, he said, of about $1.372 trillion and has capital held against those assets of about $105 billion.
If there were a one percentage point change in the risk-weightings – and the banks are required to recognise and respond to shifts in the risk environment – the risk-weighted assets would be recalculated and reduced to $987 billion. If the banks also had to increase write-offs for loan losses by one percentage point, risk-weighted assets would fall to $893 billion and the bank's capital bases would be restated at $95 billion.
In an environment where banks are also now required to use discounted cash flow valuations to bring forward the value of interest foregone over the life of a non-accrual loan (rather than recognising the loss of income within the accounting period) relatively small changes in accounting treatments or prudential settings can have major impacts on their balance sheets – and on their capacity to lend.
International legislators and regulators have belatedly recognised the role that the international accounting standards and Basel II have played in amplifying the impact of the crisis. The system will eventually produce more prudent counter-cyclical provisioning and accounting treatments that better reflect hold-to-maturity values for financial assets.
In the meantime, the pro-cyclical squeeze on bank balance sheets and their capacity to lend – coupled with their own increased risk-aversion – isn't conducive to maximising levels of economic activity or insulating this system from the after-shocks still rumbling through systems offshore.
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