Hervé de Carmoy

Unfettered finance is reshaping the world economy.
Indeed, are we not witnessing a revolution rather than a quiet transformation of the economic and financial scene?
What are the inherent dangers of this “brave new financial world”?
What should we do to minimize future risks and maximise growth and stability?

THE FACTS

The facts are identified and speak for themselves. Their sheer magnitude creates the novelty. In 2007, according to “Le Monde” (October 2nd, 2007), international reserves amounted to 5.000 billion dollars, 55 times more than in 1973, when the dollar started floating. It is anticipated that in 2007 the reserves of China will increase by about 40%, those of Russia by 65% and those of Brazil by 80%.

The inventory of global financial assets (bank deposits + government debt securities + private debt securities + equity securities) increased from 5 trillion dollars in 1980 to 140 trillion dollars in 2005, or 320% of the world GNP. In the United States financial assets represent over 400% of their GNP. The increase in the depth, breath and sophistication of financial assets has been marked in Europe. Their total reaches around 300% of the European GNP. The UK figure is around 360%. The amount of interest rate and currency swaps and options have now gone up to over 300 trillion dollars (Simon Johnson, 2007). Finally, the annual rate of growth of the world liquidities is hovering around 18%, while interest rates have dropped by over 7% over the last 15 years.

There are many more relevant figures, but these numbers suffice to illustrate the sea–change in the level of world liquidities and financial assets and hence in the complexity and sophistication of their management. Let us now attempt to gain a better understanding of the origin of the present situation.

What are the forces at work, which contribute to this explosion of liquidity and to this diversity in financial instruments?

They have been well analysed:

 First, the savings glut generated by the massive increases in the price of oil and other raw materials and by the rapid export oriented industrialisation of developing countries, notably China and India, combined with intensive belt tightening and savings by their populations. In addition, the level of these savings has had a significant impact on the lowering of interest rates.

 Secondly, science and technology. There are more engineers in the world today than the sum of all engineers trained between 1770 and 1970. An increasing number of them have been moving into the financial world. They are propagating the revolution of applied mathematics, computing and communications. Their involvement has made possible the almost instantaneous growth of an array of complex transactions, mobilizing huge pockets of money in search of maximum remuneration.

 Thirdly, there is no economic and technological revolution without a concomitant change in mentality. Derivatives, 24 hours trading, new computer based risk management models and pigeon English spread like a pandemic. Why? Because they are easy to learn by a new generation eager to get rich quickly. Real money is today the symbol of personal and social success, especially at a time when future pensions are becoming a black hole,. But the issue goes deeper. In the 21st century, it is unlikely that we will see a class war of the type experienced in the 19th and 20th centuries. It is more probable that we will witness conflicts between generations, as the major source of social tensions. The “Golden Boys” in various areas of finance are a young group, well trained technically, not inhibited by tradition, or status. They communicate mainly between themselves in a sparse language and they are mobile. They are on the opposite end of the mentality of many senior executives. The latter tend to feel that they are part of an establishment. They are seldom inclined to mental mobility; few of them have ever attempted to penetrate the world of these white shirted screen addicts. Only a small number has had the insight to learn sufficiently about modern trading and investment techniques to know what they don’t know and bridge the gap in communication, know how and mentality. This may be one of the causes of today’s problems.

 Saving glut, technology and a new mentality are not sufficient to transform the economic scene and hence the financial landscape. Another factor is at work: liberalisation and its corollary, growth in trade.. One cannot disentangle advances in technology from the emergence of a free global market. Until the 1970’s, the financial industry was highly regulated, notably in the United States. Since then, the Glass Steagle Act was removed and Regulation Q was lifted. In most OECD countries foreign exchange controls have been swept away. Finally the integration of financial markets in Europe has been accelerated since 1999. Together, all of these developments have enabled capitalism to mutate. Large numbers of people around the globe benefit now from simultaneous access to low cost credits and to sophisticated financial products. New players have mushroomed. The number of hedge funds has been multiplied by 15 over 15 years and the estimated value of their assets under management amounts to 1600 billion dollars. The same applies to Private Equity. Their reach encompasses thousand of companies of all size around the world. They have raised, in 2006, over 430 billion dollars in commitments.

 What is the end result for the world economy of all of these factors at work almost concomitantly? Clearly it is highly positive. It can be said that the world has been going through a kind of Golden Age, in spite of numerous big blows: The Asian financial crisis, the dot.com boom and bust, the sharp increases in the price of oil, 9/11, wars in Afghanistan and Iraq, all of these shocks have been absorbed without disturbing economic growth and stability. The world economies have indeed become better at taking stresses and strains. Why? Because they have become more flexible. Greater sophistication in the conduct of monetary policies (including the emergence of a competent European Central Bank), improvements in the management of stocks and goods (generalisation of “just in time” practices), expansion of the credit markets through higher liquidities and lower interest rates, as well as financial innovations have contributed to 35 years of world economic expansion at a rate of growth of 4/5% per annum. At the same time the rate of inflation has come down significantly. . However, recent events suggest that the Golden Age may be tested through converging shocks. The learning curve towards durable prosperity is steep indeed.: Discord in the credit market, vulnerability in some of the housing markets, opacity in the financial markets, could lead to troubles in the rich world economies, which in turn could reverberate globally. Let us review the majors risks behind today’s’ turmoil.

THE RISKS

One needs not be a prophet of doomsday to recognise that major dangers have already emerged in a number of areas. Figures speak for themselves: the September 2007 report of the IMF mentions, for the United States, a potential write off of 170 billion dollars of which a 130 billion dollar loss by the American banking system alone. This does not include losses in Europe and else where Amounts of that magnitude require that various types of risks materialize in a converging way. What are they?

Information technology (IT)

The first question to ask is whether IT developments used to insure the fluidity of the financial markets are secured. The answer is mixed. The number of announced vulnerabilities in computing platforms has been rising exponentially. There is no particular guarantee on the authenticity of many of the new financial screens available via the Internet, on the integrity of the data one is reading, as being accurate in real time. Many of these sites that freely provide market data are not even protected by rudimentary Secure Socket Layer encryption, on every page deployed.

Credit risks and risks of market valuation

Who can deny that the trust in the digital world is more difficult to sustain. Often, investors appear opaque. There seems to be a permanent shift to new power brokers. 10 years ago they were little more than “fringe players”. Today powerful States back investors, such as petrodollar investors and Asian Central Banks, new rich individuals, are becoming major actors, willing to take risks, without much emphasis on transparency and governance? Often they have little knowledge of each other. One cannot count on time honoured trust building measures such as personal proximity and physical contacts. In addition, disciplined credit processes have been relaxed notably in real estate and in financial markets. It coincides with the under-pricing of risk almost across every asset class over the last few years. For cost cutting considerations, the credit department of many experienced institutions have been understaffed, if not downsized, while the sale side has been expanded. So the majority of decision makers rely heavily on screens and on rating agencies. The latter phenomenon is recent.

Until the end of the 1980’s, rating agencies were hardly relevant to the good functioning of the world capital markets except for issuers like local governments. At that time, long-term syndicate loans represented 55% of international lending. Since then the world has undergone a mutation. Pension funds and other institutional investors have demanded higher yield investments. They have encouraged the growth of innovative financing instruments based on mathematical modelling: it was nicknamed “mark to model”. From that time onwards, large and smaller financial institutions securitised a significant portion of their loan books and relied on fees rather than on interest rate margins for structuring and issuing new debt obligations. They used rocket scientists to conceive state of the art financial products. Unfortunately most of these whiz kids had little knowledge of Black Monday, LTCM or of the breakdown in communication created by 9/11. The majority of the model builders had no memory of past near-disasters and most of the high up supervisors did not possess the mathematical and technical skills to control and interface with the model builders. The same disfunctioning applied to rating agencies. They did not have sufficient in-house capabilities to rate with reliability several thousand hedge funds and investment boutiques, many of which looked like black boxes.

These deficiencies may have been at the root of the present liquidity crisis. The magnitude of the problem has been made worse by several malpractices. A number of issuers invited the rating agencies to supply advisors into the process of designing innovative debt products (CDO-CLO). But, what is more, issuers of CDO’s retained the ability to “engineer” the product depending upon market circumstances. The icing on the cake was provided by many funds asking their own head of trading to prepare monthly valuations of the performance of their products and funds, rather than use in-house or external independent auditors.

All of these malpractices highlight the flawed process of corporate governance first and foremost within many financial institutions and to some extent within rating agencies. The rating agencies did step up their disclaimers, but not to the extent of the tobacco industry. Hence users did not realize sufficiently that ratings alone were simply not relevant for market valuations. They mention it in their small print. To no avail: they were not listened to. Investors in fact had few alternatives for valuation given the opaqueness of the mathematical model behind the debt obligation. A handful of them understood the technical underpinning of option pricing as developed by Myron Scholes and Fisher Black, thirty years ago.

In reality control and monitoring of the credit and market risks became diluted at three levels: regulators were requested by politicians and by the industry to dismantle many of the regulations in force decades ago. Few of them took the initiative to rewrite regulations drafted at that time for an entirely different risk profile. The Basel procedures and regulations may have had too narrow a focus. They may not have sufficiently taken into account financial innovations. The environment changed more rapidly than the practices of sound governance. National Central Banks may not have had the clout and the resources to examine lending and investing practices of all subsidiaries and affiliates around the world of the institutions headquartered in their country. In addition, many pension funds, banks, insurance companies, hedge funds and mutual funds bought, held, and divested financial assets, based on external ratings rather than on an intimate in-house knowledge of the financial products engineered and manufactured externally. Rating agencies were largely in the same situation. They may not have developed to the extent needed the expensive trading and computer skills necessary to assess both market risks, liquidity risks and probability of default. Finally, ad hoc boutiques for managing money and trading mushroomed in many places, without much supervision from financial institutions or regulators, notably in tax heavens. This is an area of distinct concern, for the worldwide framework of international cooperation in financial regulation and monitoring of new financial risks, may still leave something to be desired.

However, it is not the first time that a crisis happens. History is full of them. In the 1960’s the Chase Manhattan Bank created one of the first REIT for an amount of 500 million dollars, the equivalent of over 5000M$ of today’s money. Major investment mistakes were made which lead to the closure of the Trust. Confronted with a potential serious liquidity problem, Chase took four decisions: It negotiated immediately a five year stand –by for 500M$; it transferred to its own books all of the “sub-prime” real estate assets, that had accumulated in the REIT. To protect its own liquidity, Chase froze most of the in-house lending for about nine months. Since, as young credit officers, we had, for a while, little to do except to slow down drawings under existing commitments, we were asked to help design and draft a new manual of credit control and to cost its introduction and use. We figured out that it would represent about .3% of the bank’s margin on its new lending.

Increase in liquidity and risk of economic instability

We are entering here an area opened for debate even among economists. Is there any link between massive increases in liquidity and potential inflation and economic instability? Some link probably exists but there are other parameters that come into play. What can be said is that the sheer size and the asymmetry of the new liquidities around the world could generate, at some point in time, disorderly unwinding of global financial unbalances. This issue deserves careful expert investigation, especially in the light of the experience gathered with the present financial crisis. In retrospect, what does it teach us? One point is at least uncontroversial! We all need to go back to basics: There is a risk of corporate annihilation when financial institutions fund their medium term assets, often difficult to evaluate and partially illiquid, with short-term commercial paper.

In addition, the nature and scope of the credit/liquidity risk may become harder to quantify for any outsider. Securitisation has enabled financial institutions to do a two step dance: lay off credits which they generate on their books, often of good quality, while purchasing for their own account securities that entail other types of credit risks and higher remuneration. Few people inside these institutions, and even more so outside, will actually apprehend with accuracy the net-net exposure of financial firms that constantly change the composition of their risk assets on their books. Name lending becomes then the rule of the game, until such times as the reputations risks become a balance sheet/ liquidity risk. Obviously all of these risks are heightened by the growth of leverage. Three years ago, good quality Private Equity deals was made at leverage ratios of 3-4 to 1. In the first semester of 2007, the leverage ratio reached 7-9 to 1, if not more. As a result of the change in environment, many institutions have developed a heightened perception of counterparty exposure. Today, more than ever, cash is king and it commands a premium. This premium is apparent in the present rates/spreads of inter-bank borrowings as well as in the fire sales at deep discounts of various types of financial assets by institutions experiencing a liquidity squeeze.

Political risks

The growth of the importance of finance is likely to remain a permanent fixture of the 21st century. Yet, it is becoming clear that financial capitalism creates social and political stresses. Within many countries, relationships of power are changing and coalitions are developing to curb the impact of emerging players. The “new money”, notably in the form of Private Equity, is challenging incumbent managers and affecting ordinary people. Few of them realize the value to themselves of radical changes in the way companies are run, when in the hands of Private Equity firms. They feel threatened by a profit-seeking machine beyond their understanding and control.

On a global basis the political equation is made difficult by the income shift, from labour to capital. People’s perception is that the combination of highly incentivised managers, with their profit sharing and option schemes, together with an immense pool of uneducated and partially educated labour force from China, India, and other developing countries, creates a situation of “win all, take all”. The vast multitude of low wage and middle-income earners tend to have their remuneration stagnate, if not decline. They resent it all the more so as they do not comprehend the link between the new process of wealth creation, which probably saved their job and the disparity of income. Envy becomes a significant factor. The Golden Boys and the senior managers earn a multiple of the average employee’s wages. The difference in remuneration between the top and the bottom of the pyramid has grown over the last 15 years from 85 to 500 to 1. It could become a political issue.

There is also another political issue of great potency: Sovereign Wealth Funds (SWFs) from Middle Eastern countries, Russia, Central Asia, China and India have at their finger tips 2,8 trillions of dollars of liquid assets (“Le Monde”, October 2nd, 2007), part of which could be used to make hostile takeover bids of private national champions. Can major countries accept to have the decisions centres of such groups move to areas of the world that do not share their vision of democracy, of law and order and of national and/or regional interest? Will it be acceptable to their constituencies? Could such takeovers have a damaging social and security impact and how does one deal effectively with these SWFs? There is a need, probably with the help of Central Banks and of investment banks, to investigate and become more familiar with the staff and policies of these sovereign funds, with their corporate vision, their strategy and values in order to elaborate common rules of the game beneficial to all parties. The success of Mittal Steel in Europe illustrates a way forward that yields mutual benefits.

At this point, it is time to emphasise that each and every one of the above mentioned risk categories are manageable. Addressing them requires a concerted effort at various levels: Central Banks, financial regulators, International Financial Institutions, rating agencies, auditors, banks, funds, and insurance companies. They all have to alter their focus, step up their in-house control and consulting capacity and improve their own internal processes. Forty- five years ago, “go-go” banking was stigmatised. Half a century later there is a need to rediscover the virtues of modern professionalism in all areas of finance, which may imply, in some cases, inflicting distress and letting inefficient players disappear from the scene.

THE REMEDIES

Present turbulences reflect first and foremost the lack of transparency within many institutions, and the benign neglect with which credit risks were generated and assumed.

Too little is known at every level of responsibility and authority, in the financial world, about the practices of new players and about the way complex products are constructed, valued, managed, financed and transferred to counterparties. The same deficiency of information and risk focus applies to our understanding of the links and ramifications between significant financial institutions and a multitude of satellite funds and vehicles operating within their constellation. Some of these new entities are partially owned by good names, managed by teams that have worked in their trading rooms. Thus they can negotiate more easily money market facilities. Control exercised over their activities is often scant.

There are many ways to respond effectively to this situation. Financial players must henceforth invest heavily in internal controls. The control function should be represented at the executive committee level of most financial institutions. It should act as an effective countervailing power to the sale and trading side. It should work hand in hand with the human resources function when the time comes to develop the proper mechanisms for incentives. The potential credit and liquidity risks, notably those associated with mathematical modelling, should be properly communicated to most concerned managers in the company. Finally, if major losses occur senior management should be held accountable and not only members of the trading room.

It used to be said, “Good industry produces good finance”. The two sides of the coin are today inseparable. They are both engines of growth and development. Who can deny that active financial investors spot and correct pockets of inefficiency? They impose different management teams and disciplines, finance new activities and put traditional industries into the hands of better performers. As a result, at all levels, consumers and investors are better off. But there is one caveat: the new regulatory and governance challenges must be met with determination.

The speed and depth, at which changes will take place, could become the decisive factor in the continuation of the “Golden Decades”. All of the participants in the world of Finance have the winning cards in their hands to achieve durable growth for all stakeholders.

-Annexe-

EU roadmap aims to avoid turmoil in markets

“The Financial Times”, October 10th, 2007

European Union finance ministers yesterday agreed a roadmap to protect financial markets against future turmoil by establishing new guidelines on transparency, valuation standards and risk management. "I hope we will be able to increase confidence, because confidence is absolutely necessary for the continuation of the recovery and to avoid the transmission of the turmoil to the real economy," Joaquín Almunia, the EU’s monetary affairs commissioner, told reporters.

The four-point plan, which involves a series of expert studies to be conducted over the next 15 months, was made public as ministers acknowledged that the impact of the global credit market squeeze on Europe’s economic growth could be more severe than first anticipated. "The economic fundamentals of the euro area remain sound. There were of course disruptions in the form of the American events," said Jean-Claude Juncker, chairman of the eurozone ministerial group, referring to the US subprime mortgage crisis. "The effect of the disruptions doesn’t seem to us to be too serious for 2007, but there are downside risks for 2008," Mr Juncker told reporters.

The European Commission will update its growth forecasts for the 27-nation EU next month and is thought likely to follow other international institutions in reducing its estimates for 2008. In the roadmap, adopted at an EU ministerial meeting in Luxembourg, EU financial experts emphasised the need for enhanced transparency, particularly in the use of highly sophisticated financial products, to limit or prevent future crises.

"An important feature of the recent turbulence has been the lack of information, which raises issues of transparency in the markets for complex financial products as well as questions about how these products are valued, monitored and treated within the framework of prudential regulation and supervision," the document stated. "The absence of accurate and timely information on exposures to credit risk has been a key factor in the generalised loss of investor confidence in financial markets since August," it added.

To overcome these difficulties, the EU’s roadmap proposed four steps:

 To enhance transparency for investors, markets and regulators, especially by examining whether banks should do more to disclose the exposures of their special purpose vehicles;
 To improve valuation standards, by agreeing on a common approach to the accounting valuation of illiquid assets and examining the standards applied by non-bank investors;
 To reinforce the prudential framework, risk management and supervision of the financial sector, partly by reviewing possible enhancements of deposit guarantee schemes in the EU;
 To improve market functioning, partly by looking closely at the role of credit rating agencies, especially as regards structured finance instruments, and at the organisation of nonregulated debt markets.

Some of these issues are expected to be discussed at a meeting in Washington on October 20-22 of finance ministers and central bankers from the Group of Seven industrialised countries.

However, the proposal envisages that experts will not make their first progress reports to EU finance ministers until next March and April. Some studies, such as one focusing on how to improve global co-operation among financial market supervisors, are not likely to be completed until December 2008.

The experts’ document expressed confidence that an EU capital requirements directive, which will come into full effect next January, would go some way to improving market transparency, especially in the area of securitisation.

THE TRILATERAL COMMISSION (EUROPE)
31ST EUROPEAN MEETING
VIENNA, 26-28 OCTOBER 2007
SESSION ON THE EUROPEAN UNION
Background Paper by HERVE de CARMOY