Policy and regulation

Bank lobbying, never really went away!

From the Global Association of Risk Professionals, comes this story….

(Bloomberg) — The world’s largest banks are into the home stretch of a long campaign to convince politicians and regulators that planned changes to their capital requirements will suffocate the industry and imperil lending and growth. All that lobbying is paying off when it counts.

The Basel Committee on Banking Supervision holds three crucial meetings in the next two weeks as it races to wrap up the post-crisis capital framework by the end of the year. The banks warn that proposed changes in how they assess risk would send capital requirements spiraling, and key policy makers from Europe to Japan are heeding their message.

The banks’ lobbying success was on display this week. Andreas Dombret said the Bundesbank, where he’s in charge of financial supervision, had considered the industry’s arguments and concluded that “there is a need to recalibrate” the Basel proposals. The European Union’s top two officials then insisted in a position paper before the Group of 20 summit Sept. 4-5 that the Basel Committee stick to its promise not to increase capital requirements significantly as it refines risk measurement.

“The banks feel that there is a tactical opening right now for the politicians to deliver a more favorable outcome than what has resulted so far from the technocratic process,” said Nicolas Veron, a senior fellow at the Bruegel think tank in Brussels. “Banks in different markets and geographies have differing objectives, but there is coordination.”

Click here to read more….

Robotic finance!

An excerpt from a Harvard Business Review article (which itself is a piece from a book by Prof. Bhide) talks about the consequences of automating many finance decisions, in particular mortgages….

The traditional lending model was built around case-by-case judgment. Home buyers would apply for loans from their local bank, with which they often had an existing relationship. A banker would review each application and make a judgment, taking into account what the banker knew about the applicant, the applicant’s employer, the property, and conditions in the local market. The banker would certainly consider history—what had happened to housing prices, and the track record of the borrower and other similarly situated individuals. But good practice also required forward-looking judgments—assessments of the degree to which the future would be like the past. Dialogue and relationships were also important: Bankers would talk to borrowers to ascertain their beliefs and intentions. And staying in touch after the loan was made facilitated judgments about adjusting terms when necessary.

Over the past several decades, centralized, mechanistic finance elbowed aside the traditional model. Loan officers made way for mortgage brokers. At the height of the housing boom, in 2004, some 53,000 mortgage brokerage companies, with an estimated 418,700 employees, originated 68% of all residential loans in the United States. In other words, fewer than a third of all loans were originated by an actual lender. The brokers’ role in the credit process is mainly to help applicants fill out forms. In fact, hardly anyone now makes case-by-case mortgage credit judgments. Mortgages are granted or denied (and new mortgage products like option ARMs are designed) using complex models that are conjured up by a small number of faraway rocket scientists and take little heed of the specific facts on the ground.

The securitization and sale of mortgages has meant that financial companies’ loan origination is no longer limited by their deposit base or capital, allowing some institutions to capture a very large share of the market. Countrywide Financial, which was started in 1969, grew from a two-man operation into a mortgage behemoth with approximately 500 branches. Before it imploded, in 2007, it was issuing nearly a fifth of all U.S. mortgages. The government/private hybrids Fannie Mae and Freddie Mac made Countrywide’s role seem small. When they were taken over by the Treasury, in 2008, the two enterprises owned or had guaranteed about half of the country’s $12 trillion worth of outstanding mortgages. Since then, their share of the market has only gone up.

The buyers of securitized mortgages don’t make case-by-case credit decisions, either. For instance, buyers of Fannie Mae or Freddie Mac paper weren’t, and still aren’t, making judgments about the risk that homeowners would default on the underlying mortgages. Rather, they were buying government debt—and earning a higher return than they would from Treasury bonds. Even when securities weren’t guaranteed, buyers ignored the creditworthiness of individual mortgages. They relied instead on the models of the wizards who developed the underwriting standards, the dozen or so banks (the likes of Lehman, Goldman, and Citicorp) that securitized the mortgages, and the three rating agencies that vouched for the soundness of the securities.

Dispensing with judgment has also helped funnel the mass production of derivatives into a few mega-institutions, posing systemic risks that their top executives and regulators cannot control. (See the sidebar “Derivatives for Robots.”)

Sidebar Icon Derivatives for Robots

The fallout.

Little good has come of this robotization of finance. Reduced case-by-case scrutiny has led to the misallocation of resources in the real economy. In the recent housing bubble, lenders who, without much due diligence, extended mortgages to reckless borrowers helped make prices unaffordable for more prudent home buyers.

The replacement of ongoing relationships with securitized, arm’s-length contracting has fundamentally impaired the adaptability of financing terms. No contract can anticipate all contingencies. But securitized financing makes ongoing adaptations infeasible; because of the great difficulty of renegotiating terms, borrowers and lenders must adhere to the deal that was struck at the outset. Securitized mortgages are more likely than mortgages retained by banks to be foreclosed if borrowers fall behind on their payments, as recent research shows.

When decision making is centralized in the hands of a small number of bankers, financial institutions, or quantitative models, their mistakes imperil the well-being of individuals and businesses throughout the economy. Decentralized finance isn’t immune to systemic risk; individual financiers may follow the crowd in lowering down payments for home loans, for instance. But this behavior involves a social pathology. With centralized authority, the process requires no widespread mania—just a few errant lending models or a couple of CEOs who have a limited grasp of the risks taken by subordinates.