There’s a hint of exasperation in John Plender’s latest Insight column in the FT on Wednesday, which is not surprising given how long Plender has been warning about the problems now besetting the banking system.
It is important to recognise, he says, that the extreme nature of this financial cycle is partly the product of the very regulatory system that governs the operations of large financial institutions. Likewise, executives’ behaviour has been a direct response to flawed incentive structures in individual banks.
The Basel Accord - supposed to improve risk management - had the unintended consequence of creating a parallel banking system whose lack of transparency explains the market seize-up since August. This is something regular readers will know Plender warned about long before others:
As the new “originate and distribute” model reduced the incentive for banks to monitor the credit quality of the loans they pumped into collateralised loan obligations and other structured vehicles, the Basel rules failed adequately to highlight contingent credit risk. That is, when conduits and structured investment vehicles (SIVs) ran into difficulties, credit risk started to come back on to bank balance sheets, putting strain on bank capital.
He notes that while conventional credit markets talked about risk in terms of credit quality, defaults and ratings, derivative traders in the shadowy world of structured products employed far more esoteric language.
Yet while the cash and derivatives markets were linguistically and mentally at odds, the fundamental risks were the same. If a company goes belly-up, the credit event hurts in both places.
Bankers bonuses encouraged a perpetual dash for growth at ever-increasing risk, accountants connived in all this and capital markets investors cheered from the sidelines, without grasping the true risks.
So what now?
Basel II relies on the modelling techniques that led to the subprime disaster. The new rulebook also depends heavily on the credit rating agencies in whom investors have lost confidence. As for the evolution of executive pay structures, there is little to inspire hope.
The scale of the losses in the world’s biggest banks points to a failure on the part of boards on a monumental scale.
