Obama wields the broom.

The Obama administration has, at last, carried out it’s threat of a complete overhaul of the American financial system, not seen in the recent past.   Presently, it is a proposal that Congress has to approve, to make it law.   But from the appearance of things, it is likely to go through.

And if the reform package is approved by the Congress, it could be a real and visible body-blow to the market manipulators, and the purveyors of esoteric and incomprehensible-to-the-sensible financial instruments, that have caused so much damage to the financial system, apart from destroying the lives of so many people.

While bringing in vast returns on paper, that few would encash in the hope of making more, the loss they have brought in the wake of their failure, is real that has played havoc with the markets, and caused untold suffering to guillible and not so guillible investors, apart from affecting millions of uninvolved people.

The major areas of reforms proposed by the Obama administration are:

1. Regulation of systemic risk that can have repercussions across the system, and shake up the very foundations of the financial system.
2. To enhance transparency and strengthen disclosure norms for Banks and other financial institutions, to keep a tab on them, lest their predatory activities harm the entire system.
3. Breaking the nexus between executive remuneration and excessive risk taking.   Sky-high remuneration has been the norm for the high fliers, who took excessive risk in maximizing the profits of their firms.
4. Providing higher level of investor protection through proper regulation of the firms.
5. Prevention of regulatory arbitrage.   One of the major sources of revenues, and consequently a major source of risk to financial firms is the practice of regulatory arbitrage, that is sought to be eliminated now.

As pointed out earlier, the above proposals have to pass the Congress to become law.   One can very well expect opposition from the industry that frowns on any kind of controls to their “liberty”.   At the same time, given the current mood of the public, the Congress could well under be pressure to give the green signal to the reforms.

A major criticism of the package is that instead of reducing the multiple layers of supervision, and regulation that has not helped in preventing the kind of financial collapse that we have witnessed, the present package seeks to increase the number of regulatory bodies, while retaining the powers of the Federal Reserve, that is seen as having failed in its basic duties.

These are “interesting” times for the U.S. financial system.

The Supervisory Capital Assessment Program-Part XVIII

This is the eighteenth in a series of articles on the SCAP.

Category-wise review and assessment(contd):

Pre Provision Net Revenue:  Business projections made by the BHCs formed the basis for the analysis of their PPNR submissions.   The assessment focussed on their consistency with the overall macroeconomic scenarios.   The firms’ internal management and financial reports were also studied, to get a proper perspective of the issue.  

Supervisors reviewed the ALCO documents of the firms, to compare them with their SCAP submissions.   The ALCO, or the Asset Liability Committee, is a high powered committee in a Bank, that normally determines the interest rates to be offered by the Bank.   Supervisors also studied the yield curve assumptions, net interest income projections, and economic value of equity assessments made by the firms, in the course of their planning process.

Also examined for this purpose, were the historical trends in the major parts of the PPNR, as the net interest income, non interest income, and non interest expenses.   This data was obtained from the regulatory reports, submitted by the firms, as well as their published financial statements.

The above evaluation was done with the help of a thorough assessment of the firms’ estimates about revenues, and the risk of losses.   Wherever necessary, supervisors made changes to the firms’ forecasts, including key assumptions to ensure consistence with the macroeconomic scenarios.   Such modifications included those to the projected growth rates, and stock price indexes.   Peer analysis was another tool employed in the process and used to identify overall trends.

The historical relationship between PPNR and its main components, to measures of macroeconomc activity were also examined.   The firm-specific differences in PPNR were identified.   The components of the PPNR that were more volatile in the past were identified, as such components would be less sustainable in strained economic conditions.

After going through the above process, the lesser of the two estimates, between the firms’ submissions, and the supervisors’ estimates were applied.

Advance for Loan and Lease Losses(ALLL):   Projections were made by the supervisors, for the required level of reserves at the end of the scenario period.   Based on these projections, they developed suitable benchmarks.  

Two distinct portfolios were identified for the purpose of determining the reserves required.   One, the vintage loans left over from the end of 2008, and, two, the new credits extended over the scenario horizon.   The total of the loan amounts in the vintage category was calculated by taking the loan book balance as at the end of 2008, and reducing these balances by the estimated losses calculated.

Coming to the new loans, the figures for these were taken from the firms, or in cases, where a firm reported nil growth in new loans, the supervisors assumed this figure as being equal to the estimated loan losses between 2009 and 2010.   Sufficient reserves were sought to be built up to cover the losses on the portfolios in 2011.

Loss rates for the vintage loans were arrived at, as being equal to the firms’ 2010 loss rate, reduced by the anticipated average percentage reduction in losses in 2011.   However, for newly extended credit, to which more stringent underwriting norms were applied, loss rates by category, from 2007 were used, to represent the expected losses in 2011. 

                                                                                               To be concluded.

Acknowledgement:  Adapted from the official document of the Board of Governors of the Federal Reserve System.

The Supervisory Capital Assistance Program-Part VI

This is the sixth in a series of articles on the SCAP. 

Macroeconomic Scenarios for SCAP:  When the supervisors originated the SCAP, they had to consider its implementation with a particular background in mind.   This background or scenario had to have all the components of the actual economic environment.  

As the current economic situation is a result of the developments over a period of time, the historical perspective also had to be factored into the calculations.   Apart from this, the supervisors had to contend with the issue of forecasting a future scenario, on the basis of the past developments.  

As the current situation does not offer an encouraging prognosis, the supervisors settled upon a worse-than-the-present future scenario.   In this scenario, dubbed as the more adverse scenario, the supervisors foresaw a further deterioration in the economic situation, and the persistence of such a situation, for some time to come.

The supervisors, thus, provided two scenarios to the participating firms, to submit their projections or forecasts of the losses expected to be suffered by them, and the sources of funds and the adequacy of the same, to absorb the losses thus identified.   It would appear that the supervisors erred on the side of caution, in hypothesizing the second scenario. 

The BHCs were advised to align their assumptions in their forecasts with those behind the two scenarios presented to them, and to ensure that their specific business activities were studied against these assumptions, before making the forecasts.

The idea behind it was to make the forecasting of the firms as accurate as possible, to enable the right decisions to emerge from the exercise.   For instance, as housing loans were a major source of bad loans for the BHCs in the recent past, they were advised to  factor these loans  in their calculations of projected loan losses.   It was also felt that projections thus made under the two macroeconomic scenarios would reveal the sensitivity of the firms to various changes taking place in the economic conditions.

In arriving at the assumptions for real GDP growth and unemployment rates for the years 2009 and 2010, the SCAP teams relied on the average of projections made for these items by the Consensus Forecasts, the Blue Chip Survey, and the Survey of Professional Forecasters.   The Consesus Forecasts are carried out by Consensus Economics, a macroeconomic survey firm.  This forecast is the arithmetic average of all the individual predictions, collected for a sinle economic indicator, in a monthly survey.   The Blue Chip Survey is conducted by Aspen Publishers, who are said to have considerable expertise in conducting surveys in economics and interest rates.   And finally, the Survey of Professional Forecasters is run by the Federal Reserve Bank of Philadelphia, and is one of the oldest quarterly surveys of macroeconomic forecasts in the United States.

The SCAP supervisors have reposed faith in the value and relevance of the forecasts of the above organizations, to arrive at a fair assumption for real GDP growth and unemployment rates for the years 2009 and 2010.

                                                                                                         To be concluded. 

Acknowledgement:  Adapted from the official document of the Board of Governors of the Federal Reserve System.

The Supervisory Capital Assistance Program-Part IV

This is the fourth in a series of articles on the SCAP. 

In the previous articles, we had studied what is SCAP and its scope.   In this, and the next article, we shall study the general description of the exercise, and the various steps proposed to be taken to complete this task.

Outlines of the SCAP exercise:  As we are now aware, this exercise was caried out with reference to two broad macroeconomic scenarios.   One was the baseline outlook, which was arrived at, through consensus, among the concerned authorities;   and the second was the more adverse scenario that provided for a progessively worsening macroeconomic situation, for a more than expected period of time.  The nineteen BHCs that paricipated in this exercise were asked to submit the following data for the exercise:

Estimated potential losses on loans, securities and, trading positions:  The BHCs were advised to forecast potential losses on their loans, investments, and trading securities portfolios, including off balance sheet commitments like lines of credit, that are not yet accounted for in the Balance Sheet, and contingent liabilities, like guarantees, etc.   This information and data was sought for the period of 2009 and 2010.  

1. The supervisory team provided the participating firms a common set of loan loss rate ranges, for specific loan categories like housing loans, etc under the two scenarios laid down for this purpose.   Where the firms could prove their loan loss rate ranges to be more appropriate, they were allowed to keep the same.   Apart from this, firms with trading assets of and over USD 100.00 billion were asked to forecast potential trading related market and counter party credt losses, based on a market scenario under sever stress, like the one witnessed in the latter half of 2008.  
2. Pre provision net revenue(PPNR), and Resources available from the Allowance for loan and lease losses(ALLL):  After arriving at the figure for potential losses, the next step in the process, was to obtain a corresponding forecast of the funds or resources available to the firms, for ingesting these losses, as it were, under the same timeframe and the same macroeconomic scenarios, as applied to the first leg of the exercise.   The resources considered necessary for the purpose of nullifying the losses as above, are:  net interest income, fees, non interest income net of non credit related expenses, and reserves put in place for probable incurred losses as at the end of December 2008.  

The amount arrived at by adding up all the aboe items listed at no 2 above, alongwith the existing capital, over and above the minimum regulatory limit, would be the amount avaialbe to the firms to absorb the estimated losses under the second scenario.

The purpose of the above exercise is to determine the magic figure, so to say, of the capital that a BHC would have to have, to weather the ongoing economic storm, as well as, to lap up the losses it might incur in the second, more adverse scenario, and after all this, to come out smiling to reassure its depositors and creditors, about its capacity to take good care of their interests.

                                                                                                      To be concluded.

Acknowledgement: Adapted from the official document of the Board of Governors of the Federal Reserve System.

The G-20-Part I

Introduction:  The G-20, or the Group of 20, is a group of both developed and developing countries, that play an important role in international economic and financial matters, and are hence considered to be systemically important at the global level.

The member countries of the group are Argentina, Australia, Brazil, Canada, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, United Kingdom, United States of America, and the European Union.   The member countries are represented by their Finance Ministers and Governors of their Central Banks.   Apart from these countries, the International Monetary Fund and the World Bank are also represented in the group, on ex-officio basis.   The G-20 does not have a permanent Secretariat.

Origin:  The G-20 came into being in the year 1999.   The late nineteens saw a lot of turbulence in the financial markets of the world(that has now assumed the dimensions of a full blown recession).   It was felt, at the time, by the industrialized nations, that the earlier exclusive groups like the G-7 may not be sufficient to deal with the myriad challenges thrown up by the chaotic markets.   They then decided, albeit grudgingly, to give more scope for the developing world to play a role in discussing and debating key issues relating to the global economy.

Purpose of G-20:  The basic purpose of the G-20 is to promote and accelerate the process of development throughout the world, through a process of dialog and discussion between the industrialized world, and the emerging market economies.

The G-20 seeks to strengthen the international financial structures and frameworks through co-operation between the developed and the developing economies, and to institutionalize this process to ensure long term growth and development.   It gives voice to the less developed and emerging market economies, about their aspirations and concerns.

The G-20 seeks to understand the dynamics of an integrated global economy, and the problems and prospects of individual components of this global economy, and how to ensure a peaceful and profitable partnership betweeen these often competing forces.  

Many a time the interests of the developed and the developing economies are divergent and even conflicting with each other.   The G-20 forum promotes a dialog to resolve such issues, so that the process of development extends through the length and breath of the world.  

Historically, the marginalization of the developing world in the process of global economic governance, and the appropriation of the levers of development by the developed world led to the alienation of a good chunk of the world population.   This in turn led to the developed economies losing out on the opportunities in the emerging markets.

By seeking to include the developing economies in the formulation of international economic and financial policies, and also in the role of international financial institutions, the G-20 hopes to reduce, if not eliminate, friction between the developing and the developed world, and replace it with co-operation between the two sides.

                                                                                                              To be concluded.