Commentary

Wednesday, April 12, 2017

All the Bonds in Christendom

Part I: The Relationship Factor


Author: David Schwartz J.D. CPA

The 180th anniversary of J.P. Morgan’s birth will fall on Monday, April 17th, 2017. The great financier died aged 76, a few months after testifying before the U.S. Congress in the Money Trust hearings. By all accounts, Morgan shocked the national media when he said that a strong relationship was more important than collateral when extending bank credit. Risk management, to Morgan, was personal, concise and pithy:

A man I do not trust could not get money from me 
on all the bonds in Christendom.

 

After the September 2008 collapse of Lehman Brothers, The New Yorker magazine recalled Morgan’s common sense about relationships when explaining why the short-term funding markets had frozen over a month earlier. 

The fear that has overpowered lenders is not just about the current market chaos. It also reflects their lack of faith in the models and systems that they rely on to evaluate risk. For Morgan, that process of evaluation was all about relationships. In the modern financial system, by contrast, risk evaluation involves two things: impersonality and outsourcing. Personal judgments about the reliability of a borrower — the sort of judgment that Morgan, or a small-town banker, would make before issuing a loan —have been replaced by mathematical models. 
James Surowiecki,”The Trust Crunch,” The New Yorker, October 20, 2008

 

In the pre-Lehman mode of regulating banks, a high rating from a credit agency would be enough to justify a low level of reserves for loans. The post-Lehman regulatory response in essence has been to increase the level of collateral in banks, through higher capital reserves, while continuing to give no weight to strong relationships with customers. The social cost justification for this has been based on econometric models that suggest that higher risk-weighted asset levels reduce the probability of financial panic over time. Morgan would be appalled by such an impersonal assessment.

 

Ratios for maximum leverage and minimum liquidity have been imposed, leading to the most recent constraints, which limit the amount of credit available to any single counterparty. The closest measure of relationships in financial regulation may be the sector riskiness metrics in the asset weightings. At any rate, it seems clear that there is little consideration of character when every corporate loan carries a 100% risk weighting, while a loan cleared by a central counterparty (CCP) carries a 0% risk weight. How does that comport with Morgan's views? Is a CCP more trustworthy than a corporate or institutional customer?

 

Either strong character in financial relationships is not considered important by regulators, or they have not figured out how to create banking models that employ variables that J.P. Morgan would recognize.  

 

Industry experts have said that the current model-driven regulations will continue to reduce the availability of credit in many sectors of the economy. One must only look again at the funding markets to find justification for those forecasts. Credit has stalled for years, while regulatory limits on credit relative to collateral have increased. The experts believe that as much as 50% of the credit available will vanish from the market when the last of the new rules becomes effective. That will only add to systemic risk -- not at all what was intended by the reformers.

 

Isn’t it time for the regulators to factor the strength of relationships, not just collateral into their models?

 

(In our next commentary, we’ll look at how one regulated credit sector might add relationship factors into their models.)

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Journal Commentaries

 

Keep Regulation Functional (October 2008)

CSFME’s Executive Director Ed Blount interviews SEC Chairman Chris Cox.
American Banking Association Banking Journal
https://www.questia.com/library/journal/1G1-187494664/keep-functional-regulation-how-financial-regulation

 

The Bear Market Posse, or Counterparty Risk Management during the Recent Turmoil (Sept.  2008)

by Ed Blount
The RMA Journal, v91n1, 28-32, 5 pages Sep 2008.

 

Searching for New Paradigms at BIS (July 2008)

by Ed Blount
Unexpected deficiencies in bank capital after recent market turmoil has regulators rethinking aspects of Basel II and “value at risk.”  
American Banking Association Banking Journal  
https://www.questia.com/library/journal/1G1-181991450/searching-for-new-paradigms-at-bis-market-turmoil

 

Will Basel II Affect The Competitive Landscape? (September 2003)

By Ed Blount
Newly elected Basel Committee Chairman Caruana, Governor of the Bank of Spain, gives his views on the revised Basel capital accord, relative to its potential effects on competition and risk management in banking markets.
American Banking Association Banking Journal
https://www.questia.com/read/1G1-108008773/will-basel-ii-affect-the-competitive-landscape-the​