The Real Economy

Macroprudential regulation

Hector McNeill¹
SEEL

This is a re-posting of an article first posted in September, 2014.

There is a point of view that considers competition to be the agent of greater efficiency in the economy leading to benefits for all. One problem with this point of view is that "perfect competition" seldom exists in markets and the driving force behind business activities is profit as opposed to any contribution to "the greater good". If one looks at the abandoned city and destitution of Detroit today the saying that, "What is good for GM is good for America" rings hollow with the current state of empty motor works, houses, general social and economic depression. The blaze of attention and status given to the new world of innovation and competition in financial intermediation, that originated in the mid-1970s with the introduction of "market liberalization and competition", ended up transforming itself into a damaging relationship with the social and economic constituencies of the United Kingdom and the world. The challenge seems to be developing modes of operation that reap the benefits of competition while preventing the behaviour of firms from becoming destructively parasitic.

Background

Avoiding inconvenient powers...

Although various governors of the Bank of England have expressed their concern over the Bank's "lack of power", it is doubtful that they, in fact, desire the power needed to discipline the financial sector.

There is a tendency to prefer the more chummy theatre of mutual support and praise involving the Bank, the government and the financial sector albeit with the occasion expression of concern, gentle slaps on wrists but always with the maintenance of that stabilizing level of gravitas indicating that things are "under control". This extra-constitutional arrangement doesn't threaten to rock the boat and provides more job security for governors.

Macroprudential regulation is an approach to financial regulation aimed to reduce the systemic risk of the financial system. Emphasis on this approach increased in the wake of the current crisis. I first heard this term in a speech by the then Governor of the Bank of England, Mervyn King, who set out a convincing justification. It is a potentially important development since it could affect all economic activities directly or indirectly. However, an element of competitive philosophy is likely to derail any attempts to make this effective. The penchant of politicians for "light touch regulation" was an attempt to pay homage to the totem pole of competition and to appear non-threatening to business. This applies to several specialized areas of the economy including finance, the media and others where extra-constitutional regulatory authorities are run by the people being regulated as opposed to agencies whose modus operandi is independent and calling upon the full force of the rule of law to protect the social and economic constituencies from abuse. One only has to observe the contortions of political parties following the Leveson Enquiry recommendations or the foot dragging on financial regulation, to see case studies in the failure of government to demonstrate a concern with the best interests of the electorate. But all of this is just a point of view so it is worth looking into the decision analysis that governs so-called macroprudential regulation.

Extra-constitutional regulatory arrangements

The politicians' penchant for "light touch" regulation has led to regulatory agencies in several sectors being extra-constitutional. These are almost voluntary arrangements where those being regulated run the regulatory agency. Typical examples and finance and the media. The practical effect is obfuscation, prevarication on serious cases and the imposition of nominal fines on what, in some cases, are highly prejudicial acts. As a result fines and sanctions have become quite nominal, and although appearing to be large, for members of the public, they have become an additional marginal cost of doing business.

Law, ethics & prudence

Faced with any decision there is a need to weigh up the legal implications and to be prudent in taking the decision and hopefully that decision will be ethical in being demonstrably the right one and in compliance with the law. However, if the decision maker has an influence over the degree to which the law can impinge on the decision maker, or his company, by imposing sanctions, the decisions will be different because the costs of making the decision are less. When the overall regulatory framework is extra-constitutional it is likely that the full force of the law and sanctions will be less and in the end institutions can break the law and simply pay token fines to be entered into the accounts as a normal cost of doing business.

Not by finance alone....

Financial regulators are mesmerised by the concerns of financial intermediaries.

However the sought for stability and lower risk growth depends upon an acceptance that prudence must fall within an ethical and legal framework that includes required due dilligence standards to be applied to any microeconomic technical, economic and financial decision analysis on the use of finance.

Under such circumstances decisions remain prudential but prudence is no longer a trade-off between law and ethics but is rather orientated by "what is in the best interests of the company" with ethics and law becoming details rising to the level of, at worst, mild irritants or, at best, used to pepper public relations material on the company's upstanding "social functions".

Constitutional economics

Therefore the legislative framework required to avoid "macroprudential regulation" becoming a complete farce and failing to prevent fraud and the abuse of the social and economic constituencies is one that has a constitutional economic approach. This means that a public choice approach that encompasses the functioning of the state, communities, economic units and the individual is required. Part and parcel of this provision is the shaping of the public good of legislation. Legislation cannot avoid being intrusive to the extent of establishing regulations and procedures to be adopted that first of all are associated with effective sanctions in cases of non-compliance. Effective sanctions make the cost of decisions that contravene the law too high to contemplate. The effect is that prudential decisions tend to equate with ethical decisions and these are likely to be made up of actions that comply with the law.

Poor standards of risk assessment

If one takes the trouble to review the contributions to the macroprudential regulation discussion it is remarkable how attention is focused on things such as capital holding of banks and transparency in reporting on the sale of financial products. The debate on "prudential" policies is over-concentrated on the purely financial aspects of financial intermediaries and banks and too little on the "fundamentals" of the surrounding real economy into which banks sell their products. Most of the fraudulent dealing that "prudential" policy development is aiming to address, took place as a result of poorly negotiated and constructed financial product sales with customers in the productive sector of the economy. Most of the issues arose from an exceptionally poor standard of risk assessment both on the part of financial intermediaries and banks, on the one hand, and their customers, on the other.

I have spent a considerable period working on development projects in developing and transition economies and the current circumstances remind me of some events that I became aware of when working at the World Bank. In 1992 Willi Wapenhans, the vice president, published an internal report on the performance of the Bank's portfolio of loans² (a portfolio with an annual growth of around $21 billion at that time). He found that 65% of the loans were not performing and something like 20% of loans were made to give countries the funds to pay back previous loans, that had failed, to the bank! There was a lot of "discussion" but the Bank invested more energy in protecting the image of the institution than in solving the problem. According to Bruce Rich³

"The Wapenhans Report .... found that the whole appraisal for preparing projects was in danger of becoming a sham....over four-fifths of Bank staff interviewed felt that "the analytical work done during project preparation" had little to do with assuring an investment's social, environmental, or even economic quality. "Many Bank staff perceive [project] appraisals as marketing devices for securing loan approval (and achieving personal recognition)". It was all about pushing through a loan - fast - not to speak of personal career advancement."
.....

"It took Bank management nearly a year to formulate an "action plan" that would address the concerns of the Wapenhans Report. The first version in 1993 "Next Steps" plan was so unconvincing the Executive Board sent it back for toughening. The US director worried that it would be seen as a smokescreen, fueling criticism that the Bank was not taking concrete action. Even so, the changes in the final version were relatively minor. Ultimately "Next Steps" was a charade. It was easy to declare victory in less than a year since more than two-thirds of the 87 "actions" were bureaucratic posturing, forming committees, learning groups, and task forces; holding workshops and training courses; preparing reports (some of which the Bank had already been issuing for years prior to the Wapenhans report!), evaluations and studies, and reporting on reports and studies etc." In July 1994, right after the Bank management declared that 92 percent of the "Next Steps" had been successfully implemented, former Bank vice president Willi Wapenhans wrote, "It is perhaps noteworthy that the Bank's management response to the Wapenhans Report does not yet address the recommendations concerning accountability. The "cultural change" required is, however, unlikely to occur unless the performance criteria change"⁴

Declining standards

A need for action . .

The depletion of resources, population growth and climate change demand more effective and efficient economies achieved through higher quality investments and a better use of aid funds.

At the moment waste is almost epidemic leading to the increasing likelihood of the emergence of increasing numbers of failed states exacerbating global stability already subject to the ongoing scandal of parallel foreign policies actions consisting of cavalier and arbitrary armed interventions.

In my economic development work I have appraised hundreds of project proposals for investment as well as grants and it has become notable that the quality of proposals has steadily declined over the last 40 years⁵. In the late 1960s I attended a post-graduate project appraisal course Cambridge University where the case studies were World Bank projects. In those days the technical and economic analysis including environmental impact analysis (this isn't a recent concept) was very thorough including risk analysis relating to market prices, weather, export potential, foreign exchange earnings, import substitution and a review of investment options to select the lowest cost, most timely and lowest risk option. The notable issue today that most such analysis is absent from proposals, one is presented with a plan of activities with no risk analysis or explanation why the plan represents the lowest cost, most timely and lowest risk option.

An essential discipline in making any proposal is a thorough project design process following decision analysis principles of ensuring nothing has been overlooked. By presenting the supportive evidence of the results of a details design process it is easier to assess risk, whether or not the investment is the most appropriate compared with options and whether or not the timing is realistic. Naturally the competence and motivation of those preparing projects is an important factor in the production of objective and well executed design processes. Although this experience is concerned largely with development projects in developing and transition economies that come under the general classification of aid, there are lessons learned for the processes used in raising finance for investment and loans in the United Kingdom.

Assets substituting for risk

One obvious problem associated with investment loans is the capacity of bank staff to understand the critical factors that determine the mutual risks for both the bank and the lender associated with a loan. This is related to "fundamentals" and not to macroprudential or microprudential considerations involving financial regulations. It is related to the performance criteria used in assessing an investment proposal. The somewhat excessive use of assets as collateral to "guarantee" a loan places all of the risk on the shoulders of the borrower. If the loan does not perform they risk losing the assets put up as guarantees. If a loan does not perform the bank has the administrative legal task of transferring ownership of the guarantee assets to the bank. The practice of requesting collateral of value exceeding the value of a loan is common practice so the bank risk is low. The problem with this practice is that authorization of loans is concerned more about guarantees than the investment project design data. There are many cases where banks have taken assets of companies where there have been accusations of unethical selling with the intent of allowing a loan to fail so that the bank could take over valuable assets and make a handsome profit on the "loan cycle". Similar cases have been reported in currency and interest rates change swaps⁶ and other derivative sales where customers, in some cases other banks, were misled into thinking the financial products were of high quality and low risk. The sub-prime mortgage scandal and crisis was blamed on this sort of fraud involving rating agencies. In these cases the small print, or in those cases where there was no small print, involved assurances to customers whereas the actual characteristics of the financial product was "tails I win and heads you lose" in the favour of the seller.

Therefore macroprudential regulations need to be supported by microprudential regulations that extend into minimum performance criteria in the assessment of the object of the sale of a financial product. In the case of an investment this would entail a detailed risk assessment and in the case of a mortgage, an assessment of the capacity to repay monthly premiums. It is likely that, being badly accustomed to a world of asset guarantees, banks will be very resistant to any form of reduction in guarantee requirements. In this case the onus of risk reduction will end up in the borrower's court. It therefore becomes evident that it is potentially beneficial to explore ways in which macroeconomic policy can help companies reduce investment risks in the spirit of encouraging investment that will contribute to sustained or increased and a better distribution of real incomes.

The contribution of the Real Incomes Approach

The Real Incomes Approach, in the form of Price Performance Policy (PPP), encourages productivity and competitive price-setting for companies to secure market penetration. Under the PPP cash flow is higher. However, the cash flow is not a paper projection used to justify a loan, it is a measured cash flow based on current operational performance. PPP encourages lower prices and incremental investments in productivity to enhance the flexibility for companies to set prices at the most advantageous level. This form of growth is likely to involve lower investment outlays while generating short term⁷ returns. The likely effect of the policy is to provide incentive for firms to take up slack and to expand by applying organizational, logistics and procedural improvements to gain marginal cost reductions facilitating marginal but profitable unit price reductions. This would involve less demand for loan finance because cash flows would be higher and the generation of own equity for investment would increase. Clearly for more significant investment involving capacity expansion, loans might be required but they are likely to be deployed under conditions of performance that are more robust.

If the procedures and methodologies applied in investment project design were brought up to a good standard these could become a condition for loan approvals. It is suggested that such standards need to become part of macroprudential "technical" regulations which must be applied to financial packages whose value exceeds some minimum threshold. What cannot be alleged in this case it that such requirements are "intrusive" or "red tape" disrupting the flow of business. Such regulations are simply applying best practice in investment appraisal to loans to the mutual advantage of both parties. Banks or customers that resist such transparency should not expect sympathetic consideration if and when financial deals go wrong. For example any loan guarantee schemes should insist on adequate standards. It is worth exploring whether it would be feasible to link standards in project design to the value of assets demanded by banks to guarantee loans in a move to reduce reliance on excessive guarantees. This would not prejudice either party but could lead to a more rational basis for financial product transactions that would take place making use of more objective information as well as secure a lower level of individual and therefore systemic risk.

¹ Hector McNeill is the director of SEEL - Systems Engineering Economics Lab.
² Willi A. Wapenhans, "Report of the Portfolio Management Task Force", July 1, 1992 (Internal World Bank document),12,14.
³ Rich, B., "Foreclosing the Future - The World Bank and the Politics of Environmental Destruction", 303 pp., Island Press, 2013.
⁴ Wapenhans, W. A., "Efficiency and Effectiveness: Is the World Bank Group Prepared for the Task Ahead?" Bretton Woods: "Looking to the Future", Washington DC: Bretton Woods Commission, July 1994, note 22, CV-304. "
⁵ McNeill, H.W. & Belko, F., "Towards more effective Project Management", Series: "A Boolean Society", a publications series produced by the Decision Analysis Initiative 2010-2015, George Boole Foundation, London, October, 2011, ISBN: 978-0-907833-02-4
⁶Swaps often use a reference rate such as LIBOR which itself appears to have been subject to manipulation by some of the Banks contributing to LIBOR declarations.
⁷Short term refer to a current planning period where there have been no significant changes in plant and equipment.