Scatter the herd or financial crises doomed to recur

By Mike Dolan - Analysis

LONDON (Reuters) - However deep or long this year-old credit crunch proves to be, the financial system looks doomed to repeat the crisis in some form unless regulators look seriously at preventing banks and investors herding into booms and busts.

The pattern of the crisis that locked up world credit almost a year ago to the day is all too familiar -- years of wild optimism about credit risk sent debt assets soaring, only for the reality check of home loan defaults to trigger a sudden disappearance of liquidity and an indiscriminate collapse.

For all its idiosyncrasies, the credit jam bore the hallmark of every bubble of the past decade -- from Asia's domino-like crises of 1997/1998 to the subsequent dot.com frenzy and faint.

For sure, the history of financial excess and sudden crashes is centuries old -- Dutch Tulip-mania of the 1630s is the best known textbook warning of irrational booms and busts.

But if modern globalization, and the global financial system that greases its wheels, is here to stay, then persistently bursting bubbles of that scale every five years or so will come at a sky-high cost -- not least for the taxpayers who once again have ended up footing huge chunks of the bill.

Left to their own devices markets clearly do fail. Failure usually involves the disappearance of liquidity -- active buyers and sellers.

At that point the banks that are otherwise the stoutest advocates of markets being left alone to function to resolve their own problems, change their tune and call for governments to act as buyers of last resort to prevent systemic seizure.

Look no further than last month's multi-billion dollar bailout of U.S. mortgage giants Fannie Mae and Freddie Mac.

So what's to be done to restore public confidence and appease those seeking retribution for bankers' folly?

Writing in a forthcoming financial stability review for one Group of Seven central bank, Avinash Persaud, chairman of Intelligence Capital and financial risk specialist, said regulators should not get blinded by arguments over banker ethics and focus on addressing some real systemic flaws.

"The scale of the 2007/8 credit crunch could have been avoided by central bankers and supervisors who had both sufficient information and the necessary instruments to respond, but failed to do so for a variety of reasons," he said.

"These reasons included an absence of political will, a convenient intellectual entanglement with the prevailing zeitgeist of finance and general neglect of systemic liquidity."

MARKETISATION

Persaud and other analysts point the finger at what he calls the "mercerization" of banking, risk management and accounting rule standards -- a process positively encouraged by revamped bank standards in the so-called Basel 2 process.

The securitization boom of the past decade divorced lenders from borrowers by allowing the banks to package their loans and sell them on world markets. It transferred the risk to other banks and investors and made the market the arbiter of the cost of borrowing instead of loan officers close to the debtor.

But investors and banks using similar risk models, policed by private credit rating firms, was prone to herding.

It shifted lending out of highly-regulated, domestic banking into the laissez faire, self-monitoring world of international capital and its myriad vehicles and offshore havens. Market pricing was king as it not only reflected demand, but determined it too via the extensive use of prices in common risk models.

The result was that when the green light of low volatility said 'buy', everyone bought -- or lent in this case. When it turned red, everyone headed for the exit at the same time.

As market liquidity vanished last summer, banks and investors left holding the assets were forced to book huge losses on assets, regardless of their worth if held to maturity.

Global accounting standards, such as mark-to-market, had already exaggerated the boom by encouraging the herd to match each others' performance on a quarterly horizon, masking longer-term risk. Bankers' bonus culture pumped in more air.

On Wednesday, a banking industry advisory group headed by Goldman Sachs managing director and former New York Federal Reserve chief Gerald Corrigan acknowledged that the reward structure within banks was detrimental to stability.

"It is likely that flaws in the design and workings of the systems of incentives within the financial sector have inadvertently produced patterns of behavior and allocations of resources that are not always consistent with the basic goal of financial stability," it said.

DEVASTATING DOWNSIDE

But the flipside of the need to mark bank books to market prices every quarter proved devastating on the downside -- frontloading bank losses of a third of a trillion dollars so far, raising fears for bank solvency and boosting benchmark interbank lending rates for the world at large.

Persaud identifies this area as one of two main solutions to herding and illiquidity. Firstly, financial supervision should focus on the ability of the investor to absorb the risk in order to encourage a diversity of behavior.

For example, banks with short-term funding requirements would still need strict capital adequacy guidelines, quarterly mark to market rules and high transparency.

But the likes of pension funds or endowment funds with long-term funding could operate under less constant scrutiny, freeing them to act as risk absorbers in falling markets by removing their fear of booking losses quarterly.

Secondly, regulators need to look at capital adequacy rules that lean against the credit cycle to prevent fuelling excessive lending and deepening credit rationing and to counter the opposing influence of market prices in risk models.

This may mean having capital rations rise and fall in line with the growth of bank assets.

If lessons are learned, optimists believe the crises over the past 10 years will end up making things safer and investors will reap the benefits of a sounder system in the decade ahead.

Pointing out global equity and debt financial assets this decade mustered their lowest return since the 1940s, Jack Malvey, Chief Debt Strategist at Lehman Brothers, reckons 21st Century capital markets will be sounder than their predecessors.

"For global capital markets, the 20th century regime ended in mid-2007 rather than on Dec 31, 1999."