Survival Strategy for Financial Institutions

[sharon sanders]

Ahead of the Bell: Homebuilders

NEW YORK Goldman Sachs hosts a housing conference on Monday in New York, with presentations from companies including Beazer Homes USA Inc., Hovnanian Enterprises Inc., Pulte Homes Inc., and Toll Brothers Inc.
As the building industry battles slumping sales and home prices, housing shares have fallen sharply this year. Last month, the Commerce Department reported that sales of new homes dropped in 2006 by the largest amount in 16 years.
After setting records for five straight years, sales of both new and existing homes suffered sharp declines in 2006, spending ripple effects throughout the economy.
On Friday, Toll Brothers Inc., the nation's largest luxury home builder, said it expected first-quarter home building revenue to drop 19 percent and warned that writedowns are expected to balloon.
Last month, Pulte Homes Inc., one of the largest companies in the industry, reported a fourth-quarter loss, hurt by slumping home closings and a large inventory charge amid the weakening housing market. The Bloomfield Hills, Mich., company also said it may post a loss in the first quarter.
Pulte's struggles echo those of other homebuilders, like Beazer Homes, stung by high cancellation rates and a glut of unsold homes driving prices down.
Beazer also said last month lower revenue and hefty charges drove it to a fiscal first-quarter loss from year-ago profit.
Among the issues on the agenda is trends in credit quality. Mortgage issuers and insurers saw big stock declines last week after several lenders said bad debts are growing as more homeowners default on their loans. PMI Group Inc. Chief Operating Officer David Katkov is among the panelists scheduled to discuss credit quality at the conference.

http://www.businessweek.com/ap/financialnews/D8N86C8G2.htm

 

[sharon sanders]

Banks can avert losses

Banks can avert losses

"...<TT>Public Policy Remedies</TT>

<TT>What can public policy do to further mitigate the likelihood of systemic risk in banking and its severity if it does occur? For the sake of reality, we assume that some form of government deposit insurance, like central banks, is a political fact of life. Indeed, the evidence for countries that do not have explicit government insurance indicates that they generally have implicit 100 percent insurance. In the absence of permanently abolishing such insurance, there are three basic options. </TT><TT>[10]</TT><TT> </TT>
<TT>1. Policy can be directed at increasing macroeconomic stability and avoiding first abrupt increases and then declines (bubbles) in asset values and defaults. Schwartz (1988) and Goodhart (1995, particularly chapter 14) show that such instability has been a major cause of bank failures. Unfortunately, history has amply demonstrated that our current knowledge of macroeconomics is far short of what is required to achieve such results consistently. </TT>
<TT>2. Discretionary powers can be delegated to bank regulatory agencies to provide a safety net under banks to prevent both undue fire-sale losses from hurried asset sales by banks from affecting depositors and runs on the banking system into currency that exacerbate such losses. As noted earlier in this paper, it appears highly unlikely that such agencies, e.g. the Federal Reserve and FDIC, can do much better in the future than they have in the past in avoiding serious agency problems for themselves and moral hazard behavior by banks.</TT>
<TT>3. Policy can be directed at avoiding the pitfalls of excessively discretionary and incentive incompatible safety nets and other prudential policies and focus directly on the cause of both losses to depositors in bank insolvencies and depositor runs on banks, namely economic insolvency of banks with negative net worth. Such a policy would attempt to reduce, if not eliminate, both moral hazard behavior by banks and agency problems by regulators by properly aligning the incentives of all parties in the same and appropriate direction. The incentive for banks to engage in moral hazard behavior can be reduced by requiring sufficient private capital and imposing a series of sanctions in the form of structured early intervention or prompt corrective action on troubled banks that mimic the sanctions imposed by the private market on troubled noninsured bank competitors in an attempt to have the banks reverse direction before insolvency. The ability of regulators to incur principal-agent problems is reduced by having them be required to impose these sanctions on troubled institutions and to resolve a bank which was not turned around by these sanctions through recapitalization by current shareholders, sale, merger, or liquidation before its capital could be totally depleted and losses imposed on depositors. The best way to reduce the costs of bank insolvencies to "innocent" third parties is to restrict them solely to shareholders, who may be expected to be more aware of the risks and be compensated for them more commensurately. </TT>
<TT>Benston and Kaufman (1988, 1994a), Benston et al. (1989), Richard Carnell (1992), and the Shadow Financial Regulatory Committee (1992) describe how many of the parts of such a structured early intervention and resolution (SEIR) program are included in the prudential prompt corrective action and least-cost resolution provisions of the FDIC Improvement Act (FDICIA) enacted in the United States at yearend 1991. Unfortunately, the prompt corrective action and least-cost resolution provisions of FDICIA as well as the implementing regulations were weakened by Congress and particularly by the regulators both before and after the act was enacted, so that failure and losses will be larger than necessary. In particular, Benston and Kaufman (1994b) argue that the numerical values for the capital tripwires are set too low. </TT>
<TT>The SEIR program focuses on the following six areas:</TT>
<TT>1. Explicit full government deposit insurance for "small" depositors. Full insurance would be provided up to a specified maximum amount per account and no insurance would be provided above that amount. The precise amount at which to cap the insurance is difficult to establish theoretically, but should be near the level that depositors with larger amounts may be expected to have other investments that require the ability, knowledge, and experience to evaluate credit worthiness and may be widely expected to bear losses without much public sympathy and are unlikely to be able to conduct their business in currency and therefore run into currency rather than to other banks. These depositors would not only not be protected by deposit insurance, but would be expected to monitor and discipline their banks through market forces and thereby supplement regulatory discipline. Explicit full deposit insurance for small depositors is desirable, because (a) social externalities exist in providing a safe depository in the intermediation process for funds owned by agents for whom the costs of financial analysis of private banks outweigh the benefits, (b) these depositors are the most likely to run into currency and threaten systemic problems, and (c) insurance for such depositors is a political reality in almost all countries and explicit guarantees are more likely than implicit guarantees to avoid political battling when a failure does occur, which generally will result in the government providing full coverage and signal the willingness of the government to retreat in the face of pressure (Kaufman 1996a).</TT>
<TT>2. Capital levels on banks that are equal to those that the private market expects noninsured bank competitors to maintain in the particular country. This provision is supported by Davis (1992), Flannery (1995), and Kaufman (1992). Thus, insured banks would increase their self-insurance to more market-determined levels. </TT><TT>[11]</TT>
<TT>3. A system of graduated regulatory sanctions imposed on banks as their performance deteriorates through a series of zones (tranches or tripwires) that resemble the sanctions imposed by market forces on noninsured firms through bond covenants and creditor negotiation. </TT><TT>[12]</TT><TT> These sanctions are explicit, publicly announced, and become progressively harsher and more mandatory as the financial condition of the bank deteriorates through the tranches. (The sanctions introduced under FDICIA and the capital levels defining each tranche are shown in Table 1.)</TT>
<TT>insert Table 1</TT>
<TT>4. An explicit, publicly announced "closure rule" requiring the regulators to promptly resolve troubled institutions before their net worths decline below some low but positive critical level. The critical cutoff value of the capital-to-asset ratio should be sufficiently high so that, in the absence of large-scale fraud and unusually abrupt adverse changes in market values of a diversified portfolio of earning assets and liabilities, no losses are suffered by depositors or the deposit insurance agency. Losses from bank insolvencies are thus restricted to bank shareholders and deposit insurance becomes effectively redundant.</TT>
<TT>5. Risk-based deposit insurance premiums, both to discourage banks from assuming excessive risk and to prevent less risky banks from cross-subsidizing riskier banks. Because the closure rule should minimize losses to the insurance agency, overall premiums to be charged insured banks would be low and necessary only to cover these small losses and to finance operating costs, including monitoring market values.</TT>
<TT>6. Market or current value accounting, so that economic values rather than historical or book values are the basis for decisions by bank customers, bank managers, and regulators. This would also make for greater disclosure and transparency and increase the accountability of both banks and their regulators.</TT>
<TT>Although all six parts of the SEIR scheme contribute to its effectiveness, the key provision is the firm and explicit "closure rule." Indeed, no deposit insurance structure is effective in minimizing the costs from failures unless it includes such a rule. The prompt corrective actions increase the effectiveness of the closure rule by progressively increasing the cost to financially deteriorating banks of "gambling for resurrection" as they approach the closure capital ratio. The program must be compulsory for all banks in order that no banks remain implicitly insured. </TT>
<TT>The scheme operates more effectively if capital were measured relative to total assets--the leverage ratio--rather than to risk-based assets. This is not because the amount of capital that a bank is required to maintain by the market is not related to its riskiness, but because the necessary information appears to be too difficult to be incorporated accurately in the risk classifications adopted by the regulators. The risk classifications and weights adopted by the regulators to date have been arbitrary, incomplete, insufficiently reflective of the riskiness of the bank as a whole as opposed to individual activities, and modified to pursue political and social objectives. As a result, Elroy Dimson and Paul Marsh (1995) and Michael Williams (1995) demonstrate that they provide distorted incentives, which differ significantly from those the market imposes, and encourage arbitrage within risk classifications. Capital should also be defined to include all bank liabilities that are subordinated to bank depositors and the deposit insurance agency and are not in a position to run. Thus, bank capital should give full weight to nonperpetual preferred stock and subordinated debt with maturities of, say, one year or longer, as well as to equity.</TT>
<TT>The benefits of a system of SEIR are substantial. In contrast to most government-provided deposit insurance schemes, this structure is both incentive compatible, so that all involved parties row in the same and appropriate direction, and market oriented, so that regulatory discipline is reinforced by that of de facto as well as de jure uninsured depositors. No institution would be "too big to fail" in terms of protecting uninsured depositors, shareholders, or senior management. By providing a number of triggers for regulatory intervention rather than only one, the progressivity of severity of the sanctions will be more moderate and both the likelihood and credibility of intervention by the regulators increased. Moreover, because losses to the insurance agency are no longer a major concern, banks could be permitted to engage in a wide range of activities, at least with respect to prudential concerns. The permissibility of the activities would be judged on the ability of the regulators to monitor their values accurately and timely for purposes of prompt corrective action and resolution. It follows that more difficult to monitor activities could be permitted banks with higher capital ratios. This flexibility would provide incentives for banks to improve their capital positions and introduce carrots as well as sticks in the structure. Banks would be risking their own private capital rather than that of the insurance agency.</TT>
<TT>If structured correctly, for any given degree of macroeconomic instability, SEIR should reduce the probability of individual bank failure, the cost of failure to depositors, other bank customers, and the community, and, by reducing if not eliminating depositor losses and the need for depositors to run on their banks, also the likelihood of systemic risk. The greater the macroeconomic instability in a country, the higher would have to be the relevant capital ratios for prompt corrective action and resolution to achieve these objectives. By itself, SEIR is not a substitute for stabilizing macroeconomic policy. Although reducing the likelihood of failure, the scheme does not eliminate failure, only the cost of failure to depositors and other creditors. Thus, the exit of poorly performing banks, which is required in any efficient industry, is not affected. Banks would no longer be unique and different from other firms because of any perceived or actual greater adverse impact of their failure and therefore no longer warrant specific public policy concern for prudential reasons. Benston and Kaufman (1996) conclude that restrictions on bank product and geographic powers that may have been imposed for prudential reasons may be removed and banks subject only to those public policies applied to other industries.</TT>
<TT>Systemic Risk and the Payments System</TT>
<TT>As noted earlier, banks are closely interconnected not only by depositing funds with each other and lending to and borrowing from each other (interbank balances), but also by making and receiving funds transfers from each other in the process of clearing payments due to or from other banks (interbank transfers). Because such transfers are frequently in very large amounts, are processed almost immediately, and are highly concentrated among a few large participating banks, the impact of defaults is more likely to spread quickly to other banks participating in the clearing process and is considered particularly disruptive as it may cause at least temporary gridlock in the payments system.</TT>
<TT>Defaults in the payments clearing process can occur when the payment and receipt of funds are not simultaneous, so that funds are disbursed before they are received. As a result, credit is extended by one party to another. In generic modern interbank clearing systems, payment for individual large value transactions may be made to other banks at the time delivery is made, generally electronically by wire transfer, but final settling of net outstanding balances at each participating bank is not made until dayend. Thus, for example, a bank may accept delivery of previously purchased securities, either for themselves or their customers, in midday and pay for them at that time even though it may not have the necessary funds on deposit at the clearing facility at the time. An intraday or daylight overdraft occurs. The bank anticipates having sufficient funds in its account at dayend through scheduled inflows to settle the overdraft, but these inflows are not certain and may not occur. If they do not and represent defaults on obligations from third parties and the resulting losses exceed the bank's capital, the bank in turn will default on its obligations to other banks. Because the same funds may be transferred a number of times among banks before dayend settlement, in case of default, these transfers must be reversed in order to identify who owes whom what. This process is costly, time consuming, and disruptive. Moreover, as described in Bank for International Settlements (1994), Robert Eisenbeis (1995), Flannery (1988), Baer et al. (1991), David Humphrey (1987), George Juncker et al. (1991), Robert Parry (1996), Heidi Richards (1995), and Bruce Summers (1994), because the unwinding may result in losses that could cause other banks along the chain to default, so that losses cascade through the banking system, the payments system is commonly viewed as a source of systemic risk.</TT>
<TT>To reduce the severity of such disruptions from default, some clearing systems guarantee or provide finality for each individual funds transfer as it occurs. The costs of later, dayend settlement defaults are then borne by the sponsors of the clearing facility (house). Such finality is more credible when the facility is operated by a government agency, e.g., the central bank, than by private entities, e.g., private banks. In the United States, an example of the first type of facility is Fedwire, operated by the Federal Reserve, and of the second type is CHIPS, operated by large New York City banks. Clearings on Fedwire are thus free of systemic risk.</TT>
<TT>Except for larger and more concentrated exposures, the credit risk assumed by banks in the clearing process is little different from that assumed by them in any transaction. Thus, basically the same techniques for reducing this exposure apply. The bank needs to know and monitor its counterparties, require margin when necessary, impose maximum loan limits, and charge a commensurately high interest rate on any credit extension. The bank's own risk of default is reduced by maintaining sufficient capital in light of its overdraft exposures. The bank may also delegate some of these decisions to the...</TT>
<TT>Conclusion</TT>
<TT>The evidence suggests that banks fail. But so do other firms. Bank failures are costly to their owners, customers, and some third parties. But so are the failures of other firms. To the extent that failures reflect market forces, public policies to prevent exit harm other economic agents, such as competitors and those who will benefit from entry, including consumers of banking services. Nevertheless, bank failures are widely perceived to be more damaging to the economy because of the belief that they are more likely to spill over to other banks and beyond. Thus, almost all countries have imposed special prudential regulations on banks to prevent or mitigate such adverse effects.</TT>
<TT>This paper argues that these policies (both regulations and institutions) have frequently been incentive incompatible and counterproductive and have unintentionally introduced both moral hazard behavior by the banks and principal-agent problems by the regulators that have intensified the risk and costs of banking breakdowns. In the absence of such anti-systemic risk regulations, the greater fragility of banks did not often translate into greater failures nor did the payments system necessarily introduce greater risk for the banks. Indeed, the two periods of by far the largest number and greatest cost of bank failures in U.S. history occurred after the introduction of policies intended specifically to reduce cascading failures. The first occurred in 1929 and ended in 1933, two decades after the introduction of the Federal Reserve System. The second occurred in the 1980s, 50 years after the introduction of the FDIC to supplement the Fed. Moreover, the average annual rate of bank failures was somewhat greater after the introduction of the safety net in 1914 than before and the failure of large banks occurred only in the 1980s. In contrast, the average failure rate for nonbank firms decreased significantly. This suggests that bank instability is more a regulatory phenomenon than a market phenomenon. As Schwartz (1995) has noted, omitting the government as a cause of instability in banking in a play about systemic risk is like omitting the Prince of Denmark from the first act of </TT><TT>Hamlet</TT><TT>.</TT>
<TT>Although systemic risk may exist without government regulation, on net, the probability of instability occurring in banking and the intensity of any resulting damage are likely to be greatly increased by some government policies adopted in the name of preventing systemic risk. This conclusion is not unique to banking. For example, modifying an analogy developed by Robert Merton (1995), just as governments may reduce the monetary damage from floods by providing information about water levels to threatened home owners, they may simultaneously increase the damage by providing flood insurance and encouraging the home owners to build and rebuild in flood plains. The latter adverse affect is likely to dominate the former beneficial effect. A similar conclusion was reached by the late Fischer Black (1995: 8), who noted:</TT>
<TT>When you hear the government talking about systemic risk, hold on to your wallet! It means they want you to pay more taxes to pay for more regulations, which are likely to create systemic risk by interfering with private contracting....In sum, when you think about systemic risks, you'll be close to the truth if you think of the government as causing them rather than protecting us from them.</TT>
<TT>Governments appear to face a tradeoff between two types of banking problems--potential systemic risk from the failure of one or more banks and non-systemic bank failures from excessive risk-taking and inadequate regulatory discipline. The first problem may be solved by introducing a safety net in the form of government deposit insurance and having the central bank act as lender of last resort. But, if poorly designed or implemented, this solution is likely to increase the fragility of banks and exacerbate the second problem. Thus, governments appear to have a no-win choice. But the evidence, at least for the United States, is quite clear. The cost of systemic risk before the introduction of the safety net under banking in 1914 was far smaller than the cost of bank failures since then.</TT>
<TT>The counterproductive prudential policies have been imposed more in response to perceptions of systemic risk and "horror stories" in the popular press than in response to empirical evidence by public policymakers, who were responding to public outcries and were highly risk-averse. Similar to nuclear plant accidents, even if the probability of systemic risk in banking was very low, if it ever did occur, the expected losses would be very great, and reflect poorly on government officials and regulators. Moreover, through time, the regulators have developed a vested interest in maintaining and even expanding prudential regulations designed to combat systemic risk as they have become aware of the public prestige and power these regulations bestowed on them as protectors of society from financial collapse. In recent years, regulators have been among the most vociferous expositors and prophets of the dangers of systemic risk. </TT><TT>[13]</TT>
<TT>The best protection against widespread bank failures and systemic risk is macroeconomic policies that achieve stability and avoid price bubbles that leave banks highly vulnerable to failure. But since the success of such policies is highly questionable, backup prudential policy is desirable. This paper argues that it is possible to reduce both the likelihood and costs of future bank failures as well as any resulting systemic problems without suffering the undesirable side-effects of moral hazard and agency problems that plague many prudential policies. This result can be achieved by introducing an effective system of structured early intervention and resolution (SEIR)--a system that is both incentive compatible and market oriented. Under SEIR, bank failures would be reduced but not eliminated, so that inefficient institutions can exit the industry. </TT>
<TT>The key feature of the SEIR scheme is an explicit and enforced "closure rule" that resolves banks before their own capital is fully depleted and thereby effectively restricts losses only to shareholders. Explicit full deposit insurance is provided for smaller accounts to prevent systemic risk, but becomes effectively redundant. Because uninsured depositors suffer only small if any losses in bank insolvencies, the major transmission process of systemic risk is not activated and failures of individual banks will not spill over to others. Bank runs, even on individual banks, are far less likely than in a system without a closure rule. A system of SEIR, although in weakened form, has been included in the United States in the prompt corrective action and least-cost resolution provisions of FDICIA of 1991. Whether it will prevent repeats of the bank failures of the 1930s and 1980s, for the same degree of macroeconomic instability, depends on the ability and will of the regulators to enforce the intent of those provisions.</TT>
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<TT>http://www.cato.org/pubs/journal/cj16n1-2.html</TT>

 

[sharon sanders]

Principles to guide Private Pools of Capital -

Principles to guide Private Pools of Capital -

February 22, 2007
HP-272

Common Approach to Private Pools of Capital
Guidance on hedge fund issues
focuses on systemic risk, investor protection​

Washington, DC- The President's Working Group on Financial Markets (PWG) released a set of principles and guidelines today that will guide U.S. financial regulators as they address public policy issues associated with the rapid growth of private pools of capital, including hedge funds. The agreement among the PWG and U.S. agency principals, which will serve as a framework for evaluating market developments, specifically concentrates on investor protection and systemic risk concerns.
"The President's Working Group believes that public policy toward private pools of capital should be governed by consistent principles that set out a uniform approach to specific policy objectives," said Secretary Henry M. Paulson, chair of the group. "These principles demonstrate that U.S. regulators and policymakers have a unified perspective and are committed to providing forward-leaning guidance for the industry and its participants. These guidelines should serve as a foundation to enhance vigilance and market discipline further, which will strengthen investor protection and guard against systemic risk. We will continue to monitor developments in this ever-evolving market with these principles in mind."
The group has designed the principles to endure as financial markets continue to evolve. They provide a clear but flexible principles-based approach to address the issues presented by the growth and dynamism of these investment vehicles.
The principles are intended to reinforce the significant progress that has been made since the PWG last issued a report on hedge funds in 1999 and to encourage continued efforts along those same lines:

• Private Pools of Capital: maintain and enhance information, valuation, and risk management systems to provide market participants with accurate, sufficient, and timely information.
• Investors: consider the suitability of investments in a private pool in light of investment objectives, risk tolerances, and the principle of portfolio diversification.
• Counterparties and Creditors: commit sufficient resources to maintain and enhance risk management practices.
• Regulators and Supervisors: work together to communicate and use authority to ensure that supervisory expectations regarding counterparty risk management practices and market integrity are met.

The PWG, chaired by the Treasury Secretary and composed of the chairmen of the Federal Reserve Board, the Securities and Exchange Commission, and the Commodity Futures Trading Commission, was formed in 1988 to further the goals of enhancing the integrity, efficiency, orderliness, and competitiveness of financial markets and maintaining investor confidence.The PWG worked with the Federal Reserve Bank of New York and the Office of the Comptroller of the Currency in developing the guidance.
REPORTS

• Click here for the agreement among PWG and U.S. agency principals on principles and guidelines regarding private pools of capital

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