Wednesday, October 8, 2008

A short note on risk monitoring (fg)

One point which was not fully discussed these days in political and media circles is the manner how banks re-organized their banking activities due to changing regulation. I still can remember the debates on Basel I and Basel II. Many politicians claimed that with higher lending standards and better monitoring, banks would not fell further in love with insensate profit-risk lending practices. According to the regulator, exisiting internal monitoring of debtors was insufficient to prevent bad credit to get onto banks' balance sheets.

The consequences were shifts of bank assets away from lending on the basis of the banker’s private views about the borrower - regulators considered this hard to quantify and a little suspect – towards lending on the basis of an external credit rating. Avinsh Persaud on
One of the implications of this risk sensitivity is that bankers were given incentives to enhance the credit rating of lending to reduce their capital charges and improve their profitability. They did so in multiple ways with Bear Sterns, Lehman Brothers, and AIG often acting as the brokers. The result was that the unit of lending was no longer a known borrower, but an indivisible hodge-podge of bits of originated and purchased loans and hedges that when combined, justified good ratings.
The evolving complexity of such business activity was highly intransparent, especially for portfolio managers; meanwile the latter were heavily invested in such structured products. Now changing views on the whole issue triggered - as Persaud calls - high uncertainty premia reflected in liquidity: a revenge of relationship banking.