IMF wrote me (and all others) a letter “We would welcome views on the three key areas: surveillance, financing, and the stability of the international monetary system.”
And this is what I answered picking up on a theme that I had tried to voice while an Executive Director at the World Bank, 2002-2004, with absolutely no luck.
We have bank regulations that say that if a bank relends our deposits to a sovereign rated AAA, then it needs no capital at all, meaning unlimited leverage; if it lends to a sovereign that has been rated A+ to A, or to a private client rated AAA, then it needs only 1.6 percent capital, implying a leverage of 62.5 to 1; but when lending to small businesses and entrepreneurs, those on whom we depend so much for our jobs, those who cannot afford being rated by the raters, those who the banks are supposed to help while they make it to the capital markets, then the banks are required to have 8 percent in capital and need to limit their leverage to 12.5 to 1.
This is insane, not only because it discriminates unfairly against the natural clients of the banks;
but also because it gives immense powers to human fallible credit rating agencies, also open to capture;
but also because it subsidizes the risk aversion that already exists in the market;
but also because it turns our bankers into automats following credit ratings like if it was a financial GPS;
but also because it forces the banks to react instantaneously to the same downgrading making all take the same exit at the highway at the same time, increasing the chances of a crash;
but also because going after AAAs probably defines the mother of all pro-cyclical regulations;
but also because when something goes wrong, as it must sooner or later, even with AAAs, then the banks are left with no capital at all when we most need them to lend;
but also because it assumes the existence of real and abundant AAAs even though this must be the scarcest specie of them all;
but also because it assumes that risk lies more in what is perceived as risky than in what is perceived as not risky and which is of course pure nonsense;
but also because I cannot really think of one single bank crisis set off by something perceived as risky;
but also because the biggest profits are obtained by squeezing in under what a real AAA’s roof should look like, credit risks that are as bad as possible, placing us on a very slippery slope;
but also because I could go on and on with other similar arguments:
I knew it was insane, decades ago, and I made most of those arguments even while an Executive Director of the World Bank 2002-2004, and I read and heard much similar criticism in the pre Basel II debates.
Unfortunately, no one in the World Bank could really do much about it, because, you see, the World Bank, a development entity, has, as I see it, been tricked into having to be quite silent on financial regulations, all in the name of an misguided “harmonization” with the IMF, which is more of a disciplinary entity.
On March 18 2004 when discussing at the Board “Strengthening IMF-World Bank Collaboration on Country Programs and Conditionality” with respect to Basel II I stated “This is very clearly a case where there is a good reason for a very strong interchange of opinions between the Fund and the Bank.” Of course no such discussion occurred and in June 2004 the G10 approved Basel II.
The explanation for the silence we can find in a document attached for the September 27, 1999 meeting of the Development Committee “Progress Report: The World Bank Group’s Role in Strengthening the New International” and that states: “To strengthen collaboration in the financial sector, a joint Bank-Fund Financial Sector Liaison Committee was established in 1998. Enhanced collaboration is also reflected in the Financial Sector Assessment Programs (FSAP), jointly undertaken by the Bank and the Fund, which aim at assessing a country’s financial sector strength and vulnerabilities and at identifying reform priorities in the context of the Fund’s surveillance and the Bank’s financial sector development work.”
And, though I cannot prove it I have the impression that the discussions in the “Bank-Fund Financial Sector Liaison Committee have not been sufficiently lively and, as to the FSAP, I refer to the following that I wrote in my Voice and Noise 2006.
The Financial Sector Assessment Handbook—a postscript:
In September 2005, the World Bank and The International Monetary Fund published the Financial Sector Assessment Handbook and as I read it, it is a perfect example of what I mean by excessive harmonization, so I need to make a special comment here.
You might have already read extensively in the chapter “BASEL—Regulating for what?” about my strong belief that the world is giving too much emphasis to how to avoid crises potentially occurring in the financial sector, as opposed to how that sector is performing its role intermediating credits, generating growth, and distributing opportunities for access to capital. Yes, bank crises are setbacks, but, if in their wake they leave continuous step-by-step advances in development, we might still prefer that to a financial sector that receives a perfect bill of health but does little for the rest of the economy. In fact, such avoidance of a crisis is most probably just a temporary mirage. Developing is balancing various risks, not looking to eliminate one.
Well, in this handbook, which is more than 450 pages long, only a very few pages, perhaps fewer than ten, salute the flag of assessing and helping the banks perform their true function in development, the WB’s basic agenda. Instead, most of this handbook centers on how to supervise banks and minimize the risk of bank failures, the IMF’s basic agenda. Chapter Four contains most of the little there is about development, and “4.6.4 Development Obstacles Imposed by Unwarranted Prudential Regulation,” gives us sixteen complete lines about how entry or start-up regulation and uneven supervisory practices can hamper competitiveness and create “undue reliance on tools that are likely to disadvantage small new firms (such as excessive mandatory collateralization requirements for bank loans).”
If I have ever seen what amounts to mere flag-waving, this is it, but, on the other hand, I must admit that these flag-wavers are at least quite transparent. Under the interesting subtitle “The Demand-Side Reviews and the Effect of Finance on the Real Sector,” we can read, “development assessments are interested in the users and the extent to which the financial services they receive (including from abroad) are adequate to their needs. Development assessments must express a general view on this issue, though in many countries, especially low-income countries, detailed quantification may be beyond the scope of the assessment.
Friends, I rest my case. It is quite obvious that on this vital issue, the World Bank has been harmoniously silenced. End of quote.
Therefore, my IMF friends, all I want to suggest at this moment, for the good of the IMF, the World Bank and of course for all the rest of us, as a fundamental piece of any IMF reform, is that you… scrap all harmonization agreements and start debating with the World Bank openly the issue of what our banks are really for, because, if you haven’t noticed it, there is not a word about the purpose of banks in the 347 pages of Basel II.
Let me before ending also restate my fundamental argument by making a reference to some briefs paragraphs that I included in my Voice and Noise, 2006
We need to make more transparent our harmonization.
Some of my colleagues have expressed concerns that the paper leaves open the possibility that the World Bank Group and the International Monetary Fund may express divergent views in their assessments. But to me it would be very disappointing if diversity of opinions is not brought to the forefront of the debate, truly transparently. We and the International Monetary Fund have different development agenda, and sometimes and somehow they could be in conflict. Nothing’s wrong with that! What we cannot do is to sweep our differences under the rug in the name of some wrongly understood harmonization. What we need to do is to learn to take more of the full debates to the different capitals instead of the prefabricated and well-packaged consensus.
Otherwise instead of having Good Cop–Bad Cop strategy discussion we might end up with just a totally Blah Cop. End of quote.
IMF, I sincerely appreciate this opportunity to put forward my arguments again. I cannot swear we would have been able to avoid this crisis but I can swear that had the economists at the World Bank (and even some at the IMF) been totally free to voice their concerns about the absurdity of the regulations coming out of the Basel Committee, we would have had a much better chance of it.
Below I will append part of what I said on this issue as an ED, and if you want to see what I said about Basel regulations before and while an ED at the Bank you can find it here:
And, since then I have spoken out loudly in: "Voice and Noise on Subprime Banking Regulations", “Tea with FT” especially under the label of Subprime Banking Regulations, "Finance for Development” and of course in the not so serious but too serious "AAA-bomb".
Also searching the web you will find quite a lot in: Global Crisis Debate Vox; The Baseline Scenario; Cafe Hayek; Dani Rodrik's Weblog … and even in some of the World Bank and IMF blogs.
Now if by chance what you were really looking for is a beginner’s but all inclusive explanation of the cause of the financial crisis, written for dummies, non experts and bank regulators then I invite you to READ IT HERE
I now append here something of what I said on “harmonization” as an ED of the World Bank 2003-2004
A. The following is an extract of my formal written statement as an Executive Director delivered on March 18, 2003 when discussing: Bank/Fund Collaboration on Public Expenditure Issues. The arguments I made are equally valid for the case of financial regulations and I often made exactly that point.
“Bank/Fund Collaboration, on any topic, is of extreme importance as it can be regarded both with hope as well as with apprehension. The direct casualties on any lack of logistical coordination will of course welcome immediately more collaboration, but, others might feel that there is an impairment of the value and transparency of public debate, when entities with quite different responsibilities and horizons, almost publicly agree to publicly agree, as a way of life. …
As the paper is intended to be made public we believe that for clarity it would benefit from a different structure, for instance by separating, preferably into different papers, the following issues:
1. Coordination of activities… the avoiding to step on each other’s toes or more importantly, on governments’ official toes…. a technical paper… not restricted to the Public Expenditure issue.
2. The second paper should exclusively address the fundamental issue whether the world would benefit from a closer Bank/Fund cooperation. In this respect, and as a matter of principle, we truly believe that consensus should be welcomed, but mostly when it is the result of a heated debate. We believe that we should shy away from anything that indicates a pre-planned consensus, as this is probably the number one cause of death of all the questioning and creativity that today’s developing economics so urgently needs.
3. Finally, and only after both previous issues have been adequately clarified, would it be time to analyze the specifics of collaboration on Public Expenditure issues. In doing so we also believe it beneficial to try to identify more clearly the traditional differences in opinions between the two entities – for instance with regard to the volume and structure of public expenditure, so as to be able to much clearer focus on the probable implications.
In this respect, in our opinion it does not sound like a good idea to force an ex-ante collaboration, in topics, that by nature should be considered from different angles, most specially where any differences in opinions and proposals are supposed to be sorted out later through political processes, in the respective countries.”
Also from the discussion of the previous I extract, verbatim from the formal transcripts, the following comment:
"Collaboration should not be measured, in my view, in terms of expediency and effective management between the Fund and the Bank but in how that collaboration really means to strengthen the voice of the countries. And in that sense, a country’s voice is strengthened always by learning to manage differences in the debate, not just by ignoring them or eliminating them. So I do think that some type of perspective, all the time reminding of the country ownership, has to be a little more pointed out.”
B. The following is from the verbatim transcripts of what I said when discussing “Strengthening IMF-World Bank Collaboration on Country Programs and Conditionality—Progress Report on March 18, 2004.
"…two brief comments, the first on the importance of making clear that even though there are still specific differences between the Bank and the Fund, more than cooperation—it sometimes even requires some antagonism and discussion to really get to the depth of the issues.
And we want to make, for instance, one big example. Last week we heard the Global Development Finance Report where it was stated that in respect to the new proposed capital accord by Basel the following—that it will involve significant compliance costs for financial institutions—that there is a fear that implementation of the Accord may further discourage bank lending to developing countries—that the proposed Accord pays insufficient attention to the benefits of diversification and may overstate the risk of lending to developing countries as a result—that it will accelerate the process of disintermediation; that there is a clear risk that implementation of the Accord will amplify procyclicality of bank lending.
It is not clear that the Accord will fully achieve its central aim of establishing a level playing field for internationally active banks. As a result the new Accord is likely to result in very undifferentiated risk-weights for developing country banks; focusing on less risky borrowers, while domestic banks is concentrating on high-quality borrowers with potential risks for the health of the domestic banking system.
And there are a couple of more risks. This is very clearly a case where there is a good reason for a very strong interchange of opinions between the Fund and the Bank. I know it is assuring but we should in all this collaboration discussion, at least remind there are still some very strong discussions needed on other issues.
Secondly, just to question the use of surveys in these type of things. On page 13, we find that, for instance, 69 percent of Bank-Fund staff believes that programs are largely or substantially aligned with the country’s own development strategy although ten percent of Funds respondents and 13 percent of Bank respondents found little or no alignment.
In a question of that sort, it is much, much more interesting—we learn much more through really getting down into a detailed analysis of those 10 and 13 percent who believe they are not aligned than just going out on a general service system whether it is aligned or not. And I do think that these types of surveys should go further into detail—there might be very useful lessons—and not let ourselves to be guided by the implicit correctness of the majority."