Tuesday, December 8, 2009

BIS Issues Low Interest Warning AGAIN

The Bank of International Settlements, the world's Central Banks Bank, has again issued a warning to Central Bankers that low interest rates foster risk taking.  In my post below, "The FED, Asset Bubbles, AIG, and Fraud", I referenced BIS reports going back several years that low interest rates encourage risk taking and how the Fed ignored the BIS reports prior to the current Financial Crisis and continues down the road of another new crisis which is the same as the old crisis.  The Overview of the BIS report said, "The low interest rates in the advanced economies, combined with the earlier and stronger recovery in a number of emerging economies, continued to drive significant capital inflows into emerging markets, particularly in Asia and
the Pacific. Although difficult to quantify, a related development was increasing FX carry trade activity funded in US dollars and other low interest rate currencies. The result was rapid asset price increases in several emerging economies as well as substantial exchange rate appreciation with respect to the US dollar".  The actual chapter on monetary policy and risk taking said, "Easy monetary conditions are a classic ingredient of financial crises: low interest rates may contribute to an excessive expansion of credit, and hence to
boom-bust type business fluctuations."

In the my post which I referenced at the beginning, I also referenced a Raw Finance article on "Meet the New Crisis, Same as the Old Crisis".  The New BIS report which repeats yet again the same warning they have issued for several years.  Baseline Scenario recently had an article on "Measuring the Fiscal Cost of Not Fixing the Financial System" in which Simon Johnson said, "At the heart of every crisis is a political problem – powerful people, and the firms they control, have gotten out of hand.  Unless this is dealt with as part of the stabilization program, all the government has done is provide an unconditional bailout.  That may be consistent with a short-term recovery, but it creates major problems for the sustainability of the recovery and for the medium-term.   Again, this is the problem in the U.S. looking forward."  He also said the the US crisis has worsened as a direct result of how the FED and Treasury dealt with the financial crisis and " Even more problematic is the underlying incentive to take excessive risk in the financial sector.  With downside limited by generous government guarantees of various kinds, the head of financial stability at the Bank of England bluntly characterizes our repeated boom-bailout-bust cycle as a “doom loop.”  The implication is repeated bailout and fiscal stimulus-led recovery programs."

Joseph Stiglitz has written yet again in "Too Big to Live" that the global controversy on whether banks are too big to fail and what regulations are needed, but it boils down to the bankers either swindled their shareholders and investors or they did not understand the nature of risk and reward.  The condition then becomes, if they are permitted to survive, the smaller the entity the easier it will be to regulate them for the protection of society.  Size itself is not the real issue it is whether the bank/shadow bank in its conduct presents itself as a systemically dangerous firm by its business activity: "Too-big-to-fail banks have perverse incentives; if they gamble and win, they walk off with the proceeds; if they fail, taxpayers pick up the tab.
·        Financial institutions are too intertwined to fail; the part of AIG that cost America’s taxpayers $180 billion was relatively small.
·        Even if individual banks are small, if they engage in correlated behavior – using the same models – their behavior can fuel systemic risk;
·        Incentive structures within banks are designed to encourage short-sighted behavior and excessive risk taking.
·        In assessing their own risk, banks do not look at the externalities that they (or their failure) would impose on others, which is one reason why we need regulation in the first place.
·        Banks have done a bad job in risk assessment – the models they were using were deeply flawed."

Stiglitz's recommendation is very rational: "These are not matters of black and white: the more we limit the size, the more relaxed we can be about these and other details of regulation. That is why King, Paul Volcker, the United Nations Commission of Experts on Reforms of the International Monetary and Financial System, and a host of others are right about the need to curb the big banks.  What is required is a multi-prong approach, including special taxes, increased capital requirements, tighter supervision, and limits on size and risk-taking activities."

But we are already seeing how the howling and circling packs of lobbyists are diluting and milking attempts at financial reform to benefit the large banks and the shadow banks as they have become larger, resumed their risk taking, and remain without sufficient regulation of their business and trading activities.  The stage is set for an encore performance.

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