The Critical Slipping Cog in the Global Financial Machine

There are many regulatory flaws that contributed to recent asset inflations – the Japanese boom, the tech boom, the housing boom, the derivatives boom – and their subsequent collapses, the most recent precipitating the current dramatic global financial crisis.

However, one flaw is very basic. It appears to have led to a loss of central bank control over monetary policies in many countries at once. This allowed, over the past decade, a vast, unintended global excessive monetary ease which inflated the dangerous asset bubbles whose catastrophic bursting has led to the now-unfolding global economic havoc.

I posit that this critical slipping cog is a mismatch between the risk-ranked capital adequacy requirements of the international Basel Agreements and the unsupervised private risk rating of bank assets. This mismatch has caused a loss of central bank control over their own aggregate effective required reserve ratio, because someone else is setting the risk-level. This has caused central banks to lose control of monetary policy and that policy to be more lax than intended; this has caused asset bubbles. The Basel Agreements set up a system of bank capital adequacy requirements with widely divergent required reserves for bank assets of differing risk levels.

So, for instance, a bank with an asset portfolio consisting exclusively of real estate mortgage loans, generally rated high-risk, would be required to hold 8% of the value of those loans as cash reserves with the central bank, while a bank with a portfolio consisting entirely of major-country government bonds, generally rated AAA, would be required to hold only half a percent of the value of those assets as reserves. A range of required reserves from half a percent to 8 percent is very wide and slipping along that range would cause monetary policy to shift from extremely lax to extremely tight, all else equal.

It is this required reserve ratio (rrr) which determines the rate at which increases in the monetary base, controlled by the central bank, propagate and multiply through the banking system to generate the broader components of the money supply, thereby effectuating monetary policy changes in the real world. Increasing the rrr tightens monetary policy and the inverse. While these bank asset risk ratings are critical to the conduct of monetary policy, as in aggregate they determine the global rrr, these ratings have historically been set by ratings agencies, such as Moody’s and Standard and Poors -- private entities in the pay of issuers of the assets being rated.

This is not a problem if, despite the hazards of the pay structure, ratings are generally stable, even if isolated cases are randomly off-base. But, what happens if a generalized, broad-based inflation of the ratings of a high proportion of all bank assets outstanding occurs? What happens if these private ratings agencies begin to issue higher-than-warranted ratings on, not just a few assets as an aberration, but as a general rule, across a high share of the assets in the system? What happens is the ratings agencies have just unilaterally relaxed monetary policy by reducing the effective system-wide rrr. Monetary policy has been relaxed quite unbeknownst to the central bank, which thinks monetary policy is unchanged as its interest rates and monetary base targets remain unchanged.

The effect is even more profound when entire classes of high-risk assets, which should require a high level of reserve, are re-classed as low-risk due to their bundling by the holding bank with CDSs that purport to “insure” the assets against default. If such bundling is accepted by central banks as sufficient to allow reclassification of assets as lower risk (which apparently it was by bank regulators globally) this would allow an unregulated, unstable product, if widely used, to cause a generalize decline in the required reserve ratio.

I posit that widespread inflation of ratings led to a generalized decline in the required reserve ratio over the past decade, at least. This has caused monetary velocity to increase substantially and to allow a huge expansion of global broad money supply without any deliberate action toward that end taken by any central bank. Possibly much of the demand for the infamous CDSs was led by banks’ desire to use these cheap, unreserved-for, bits of paper to artificially improve the ratings of their assets as this would thereby cause the central bank to reduce the asset-holders’ required reserves under Basel II, which would lead to an increase in bank lending and bank profits.

Even if the inflated ratings were happening in only one jurisdiction, such as the US, the effect would become global to the extent that the over-rated assets were purchased by banks in widespread locations. Worldwide, Basel II would then call for a reduction of the effective rrr in any and all jurisdictions into which the the over-rated assets had moved.

Such movement is, of course, free and controlled by private actors. It is this effective global, unintended relaxation of monetary policy which generated the wave of loanable funds which fueled excess “subprime” lending. Subprime lending would never have happened if the quantity of bank loans seeking a borrower had not been expanded artificially by the slipping cog of reduced reserve requirements. It is merely chance that the wave of excess credit found its way through avenues of least resistance into the hands of marginal, low-income homebuyers in places like Las Vegas. If the excess money hadn’t gone there, it would have slopped over somewhere else. The fundamental, underling flaw in the system was in allowing private, unsupervised ratings companies defacto control over the required reserve ratio through their ability to jigger with the risk-rating of bank assets.

To reiterate conventional wisdom, this monetary ease led to asset bubbles instead of generalized inflation due to the strong anti-inflationary effect of the downdraft on wages caused by the entry of millions of low-wage workers onto the global labor market with the opening of the FSU and China. This was observed for the first time in the Japanese experience of 1986-1993. These bubbles are inherently unstable and dangerous.

How to fix this, so we can prevent a recurrence? I would propose that all bank asset ratings be done by a branch of each national central bank or by divisions of major central banks – the European, American and Japanese, at least. Existing private ratings companies could be nationalized and their employees made government employees on set salaries or the bureaucracies could be built up organically through government hiring. The costs of this system should be paid with an annual fee levied as a percentage of banks’ reserves held with the central bank. The average aggregate risk-rating of all bank assets in a given jurisdiction should be computed periodically and held stable over time unless there has been an actual, exogenous improvement in the quality of all bank assets.

Comments

[Rokjok777:]

Superb. Call B. Obama immediately, they could use some good critical thinking at this stage. Seems to me that he's recycling old remedies with little new inputs. And I voted for him!

2008 Nov 30 04:33 AM

[Rumpole:]

When you said: "...What happens is the ratings agencies have just unilaterally relaxed monetary policy by reducing the effective system-wide rrr. Monetary policy has been relaxed quite unbeknownst to the central bank, which thinks monetary policy is unchanged as its interest rates and monetary base targets remain unchanged."

"Unbenownst" is not the word I'd use to describe central banks in this situation. I find it very difficult to believe central bankers were unaware of the effect that private rating agencies were having.

And with the more recent actions of the central banks especially the Fed, are you so sure central banks would do a better job on ratings than the private agencies? Ballooning its balance sheet with so much toxic assets doesn't inspire confidence!

2008 Nov 30 09:07 AM

[Prudent Man...:]

Good stuff!

Fifty years ago the FRB would never have allowed itself to be characterized as a "Central Bank" as that moniker connotes political control, which at the time was , as now, is a correct appraisal. One important tenant of the Free Enterprise System is the allowance of failure. No enterprise should even be allowed too get to big to fail as, by definition, it is monopolistic or oligopolistic hence anti-Free Markets.

Keynesian economics', which has raised it ugly head again, main fallacy was that because politicians never want to take away the punch bowl, they will never stop spending what they don't have to prime a pump that doesn't need priming. As differentiated from the arrogant Galbraith when he wrote that the average individual is incapable of making sound economic decisions ( a belief of most politicians) it took statists, like him, to make those decisions for them. Keynes, on the other hand, understood this and made a fortune in the stock market, then got out.

The non-term-limited Congress loves printing money until the bubble bursts. After all, members of the House of Representatives must be re-elected every two years and they don't want any economic slow down of their watch. Political survival and expedience is more important than doing what is good for the country.

A good start on limiting these boom and busts cycles would be to distance the FRB further from the "Central Bank" designation and put term limits on Congress ridding us of the Chris Dodds and Barney Franks who have much more economic power activity than all of the reborn Clintonites in the Obama Administration, including Obama himself which he will soon realize as Bill Clinton did in 1993. Furthermore, Franks and Dodd are not held to any responsibility for their recklessness that borders on criminality.

2008 Nov 30 11:42 AM