Plagiarism by Proxy

It’s indicative of the utter bewilderment amongst Tories in the face of the current banking crisis that their attempts to spin thing to their political advantage turns up such a rich array of delightfully Freudian slips, as is evident from this delightful effort from the keyboard of Iain Dale…

I don’t often quote in its entirely a bogpost [sic] from another blog, but this one from ConservativeHome’s Tory Diary merits an exception. Over to Tim Montgomerie…

Bogpost is about right as Iain goes on to quote Tim Mongomerie’s attempted puff piece which begins with an attempt to big up da Cameron massif…

There’s been a lot of criticism of David Cameron recently but this extract of a speech that he gave more than six months ago showed a pretty good understanding of the issues of capital inadequacy and illiquidity at the heart of this crisis:

Before quoted from Cameron’s speech, which was given on 28th March 2008…

“As well as the reforms we have outlined for the UK financial system, we need reforms at a global level too. So let me suggest one important reform that needs to take place in light of the recent crisis in world banking.

“The Basel capital accords determine how much capital a bank must set aside for a given amount of lending. This makes good sense, and, for obvious reasons, it is right to set the rules at a global level. But economists have identified some key problems with the current Basel accord. “First, the rules on liquidity, which has been at the core of the current crisis, are too weak. Banks can operate with enough funding only to survive for a couple of weeks, but still be within the rules. Second, we need to examine which asset classes and which institutions are covered by existing rules. For example, the zero-weighting of some triple A assets has led to distortions in asset allocation. Put simply, some of the debts were kept off balance sheet so they didn’t count as lending under the rules…

…In short, liquidity risk was all but ignored, credit risk was delegated, and market risk was backward looking. And we now know that not only did the regulators not know, but too often the banks themselves didn’t know, the full extent of the risks they were subjected to. But let me say again, any reforms at an international level will need care to ensure that in tackling the past problems they do not create the problems of the future. At the same time, we must all recognise that crises are inevitable, so a prudent Government, as we will be, that is committed tol be, must improve our response to these crises when they appear.”

Which is not such a bad assessment of the situation, albeit one that Cameron could easily have picked up from a subscription to The Economist, but then – oh dear – Tim just has to try an get in a dig at the government…

Now, I don’t remember Gordon Brown anticipating the banking crisis in this clear way, do you?

Well actually, Tim, I do…

On taking forward measures to promote stability in financial markets and address what we call a transparency deficit, we are agreed we should be guided by the following principles. Primary responsibility for managing risks is, and must remain, with financial institutions and investors who must take responsibility. This needs to be backed up by national regulatory and supervisory frameworks that are strong and each country has its own proposals. Authorities need to cooperate and exchange information effectively within the European Union and internationally to prevent and manage crises and contagion. Based on these principles we are calling for greater transparency to secure better informed markets and we want to see in this greater transparency improvement in the information content of credit ratings to increase investors’ understandings of the risks they face, and we stand ready to take regulatory action if progress is not made. Greater transparency by the major audit firms and supervisors delivering clear and consistent guidance on the valuation and disclosure of financial institutions’ off-balance sheet risk, prompt and full disclosure of the losses banks and other financial institutions face, and the Basel Committee of Banking Supervisors should bring forward standards on improving the international management of liquidity risks.

Okay, so its Gordon-speak so maybe describing as clear could be considered to be stretching the point, but these comments, from a joint press conference with other EU leaders (Barroso, Sarkosy, Merkel and Prodi) which took place on 29th January 2008 (that’s two month before Cameron’s speech) covers the same basic ground and issues…

…not that this should come as much of a surprise as more a month earlier (19th December 2007) the Financial Services Authority were on the same basic track

The FSA said banks testing their models should consider customers’ behaviour and the effect on deposits as well as stresses from off balance sheet vehicles — the focus of uncertainty in the recent crisis — including legal and reputational strains from those vehicles.

Banks should also test their liquidity “insurance”, including what assets they hold as treasury and whether liquidity promises from other banks can really be called upon.

Liquidity — or lack of it — is typically the cause of bank failures and is one of the top risks for institutions on the sector, but bank rule books such as the Basel II supervision rules have focused instead on capital requirements.

But the grand prize in the ‘who thought of it first?’ stakes goes to the Labour Peer and former Chief Economic Advisor to Neil Kinnock, Baron Eatwell of Stratton St Margaret who wrote in the Observer:

The principles underpinning Basel II are a reaction to the failings of the 1988 capital adequacy rules that are now frequently circumvented by clever financial innovators. Future capital requirements are to be far more flexible, and more closely aligned to free market forces.

Basel II is built on three pillars: Pillar One – the determination of regulatory capital, heavily influenced by the use of banks’ internal risk weighting models and the views of ratings agencies; Pillar Two – banking supervision; and PillarThree – market discipline enforced by greater disclosure of banks’ financial status and their internal risk management procedures.

In normal times the Pillar One and Pillar Three proposals may promote stability. But when a crisis hits, they will make things worse by strengthening the very forces they are supposed to counteract.

First, firms’ internal risk management systems are, by definition, market sensitive. The models may differ in detail, but they are constructed on similar analytical principles, estimated on similar historical data, and sensitive to the same market information.

Good risk managers hold a portfolio of assets that are not volatile and the prices of which are not highly correlated – not correlated in normal times that is. But in a crisis the volatility of a given asset may rise sharply. The models will tell all firms to sell. As all try to sell, liquidity dries up. As liquidity dries up, volatility spreads from one asset to another. Previously uncorrelated assets are now correlated in the general sell-off, pumped up by the model driven behaviour of other institutions caught in the contagion. So whilst in normal times models may encompass a wide range of behaviour, in extreme circumstances they will encourage firms to act as a herd, charging toward the cliff edge together.

Second, the emphasis on disclosure reduces the diversity of information that has in the past created diversity of action. Today, information is ever more readily available, and disclosure of price sensitive information is legally required. Insider dealing on private information is, rightly, characterised as market abuse. But the attainment of equal information is bought at a cost – increased likelihood of herd behaviour as all react in the same way to the same news.

Third, it’s no good relying on Pillar Two (enhanced supervision) to reduce herding. An essentially subjective, personal interaction between bureaucrat and risk-taker will be neither consistent nor effective, particularly on an international scale.

So, in extremis, when regulation really matters, it will work the wrong way, reinforcing destabilising behaviour. All this is not confined to banking. Regulators are responding to seamless financial markets by requiring common rules. Sir Howard Davies of the Financial Services Authority has argued that in banking and insurance ‘where the risks are the same, the capital treatment should, in principle, be the same’.

The core idea of Basel II is that market disciplines, whether direct or mediated through banks’ own risk-modelling, should be placed at the heart of financial regulation. But the reason regulators exist is that markets don’t always work efficiently to achieve society’s goals. Just as the environmental watchdog is there because the market encourages polluting behaviour (imposing costs on society as a whole rather than the polluter), so the financial regulator is there because financial risk takers expose society to far greater losses than they might suffer themselves.

The situation is made even worse by the IMF’s plan to impose Basel II throughout the world. Handing financial regulation back to ‘market discipline’ will nullify the progress that has been made to create a system of international regulation.

Efficient regulation requires that the domain of the regulator should be the same as the domain of the market. There have been some important improvements in the past decade, notably Gordon Brown’s success in persuading the G7 to set up the Financial Stability Forum. This brings together national regulators, central banks, treasury departments and international institutions to tackle international financial problems on a coordinated basis.

Nonetheless, the international regulatory structure remains limited, patchy, even incoherent. It has developed in response to crises rather than as a coherent reaction to the international transmission of financial risk. Basel II should provide the intellectual rigour that has been lacking. It fails to do so.

And the date of that article?

Sunday June 9 2002 – more than five years before the beginning of the current crisis!