Sub-Prime Crisis Not Over Yet

Source : The Business Times, April 18, 2008

By SURESH MENON, FOREIGN EDITOR

HOWARD Davies, the director of the London School of Economics (LSE), has served the global financial community in various ways. He was the deputy governor of the Bank of England, chairman of the UK's Financial Services Authority, director general of the Confederation of British Industry and Controller of the Audit Commission. In 2004 he joined the board of Morgan Stanley as a non-executive director. To top it all in a literary way, in 2007 he chaired the jury of the Man Booker Prize for fiction.

'The crisis is not over. Fed actions may have reduced the panic, but the downturn scenario for the rest of the year still remains.'- Mr Davies

Last week in Singapore for the LSE Asia Forum 2008, he spoke to Business Times exclusively on the sub-prime contagion and the global financial architecture.

Excerpts from the interview:

Are we anywhere near an end to the sub-prime crisis?

We are not fully through this crisis. In the US, big investment banks have now taken most of the pain. A little bit more is possible if house prices continue to tumble. Mainly, they have provided for that. They have also taken most of the heat from the leveraged financing and private equity loans they committed to in good times, which are now loss-making. But still more remains to be disclosed in other parts of the market and some US regional banks or European ones have not reported, or written down, their exposure to adequate levels.

Big banks are not in such a bad position after the Federal Reserve opened the discount window. Liquidity fears are dying compared to the time of the Bear Stearns debacle. Things are getting better on Wall Street. But with the US economy into a recession, you have different classes of losses emerging - not the exotic types like financial engineering, etc ... Ordinary corporate loans are bound to rise. Consumer credit will decline in quality. So a second wave of losses is emerging. Also, one cannot really see any signs of big hedge funds saying things have bottomed out. So in that sense this crisis is not over. Fed actions may have reduced the panic, but the downturn scenario for the rest of the year remains.

Talk about central bank intervention, government supervision and regulatory regimes is becoming more pronounced.

It's clear that there will be regulatory changes in the US as a result of the Fed opening the discount window and accepting more collateral etc.. The Fed is not likely to carry out that regime without wanting something in return. That something could be reduced leverage in the investment banks. There are already discussions between the Fed and the investment banks on that. Also the rating agencies would be required to segregate their business and their consultancy to avoid conflicts of interest. That is pretty much inevitable.

Changes to Basle II (the 2004 accord on banking laws and regulations including capital adequacy ratios, etc) to make it more sensitive to liquidity are underway as well. All these are natural consequences to what happened. Also, there is a lot of political noise by people who do not know what they are talking about. That will take time to settle down.

Leaders and institutions feel they need to come out with some statement about regulatory initiative. Most of it does not mean anything. What emerges from the Financial Stability Forum is likely to be the key. There is also this big agenda for the banks themselves to pursue. Banks will have to improve themselves.

Do you expect any more Bear Stearns? Citibank going bust, for instance?

Well, not Citibank. The Fed would step in or else that would cause problems all over, including in Singapore. Also, big banks have access to liquidity. But it would be surprising if there were no other failures in the US and elsewhere - but probably not systemic bank failures. Germany and UK have witnessed some failures. More could happen elsewhere and even in Asia because many have been slow to report.

Where do China and India fit in? Do they have the ability to cushion the shock?

Chinese and Indian banks have not been massively affected. They were not big in the sub-prime market. One consequence of the US slowdown would be reduction in the US trade deficit, which is already happening. Chinese exports grew only 6 per cent last year against 20 per cent before. India is more reliant on domestic demand than exports, unlike China. But China's growth also is more rebalanced now towards domestic demand. But one cannot decouple globalisation and all the other things happening around. There will be an impact. If the US recession is not long and deep, there will be only a shaving of growth rates in India and China and not a complete collapse.

What about headlines like 'Is capitalism dead'? Do you expect pressure on countries and leaders not to let free markets prevail in the long term?

There are both political and technical debates on this. The technical debate is, to what extent central banks take into account asset prices while setting the monetary policy. That is a 'bloodless' way of asking the question whether capitalism is dead. In other words, the debate is whether central banks should take notice when irrational exuberance is underway in the market. People who say 'yes' are winning the argument. They are persuasively arguing that central banks should not ignore asset prices like before. Inflation in stock prices or property need to be taken into account.

A change in central banking orthodoxy is likely because of this crisis. That may lead to a more interventionist approach by them in the asset market. A massive reaction against 'Anglo-Saxon capitalism' is probably not likely.

The distribution model is under some threat. A tilt back towards more conventional banking practices is possible. Legislation to ban certain practices in capital markets are relatively unlikely. What we will see is a variety of technical central banking responses depending on the recession and pick-up scenario. If the world falls into a major recession, political forces then will become much stronger. That scenario is hard to predict. Despite the pessimistic scenario I don't see a deep or global recession.

In your book (Global Financial Regulation, The Essential Guide) you argued that there should be more participation of developing countries in global financial institutions.

There is a big issue there of legitimacy. The Basel committee has 13 members, 10 from Europe. In the banking system, three of the top 10 banks are Chinese. It's pretty crazy they are not involved. Western governments have been very slow to recognise the implications of globalised financial markets. For instance, the Basel II capital accord was devised entirely without reference to Islamic financial institutions. We need to have more representative bodies.

You cannot expect countries like India and China to follow these rules when they were not consulted in the first place. But it also requires countries brought in to behave in a different way. You now have emerging market representatives in some international bodies who sit there and think how does this affect their interest. You can't be like that. You have to leave your Chinese or Indian attire at home and cooperate to make global rules for the general good. Europeans and Americans do that. But one must admit it's also part of a general issue, as is the case with the UN Security Council representation.

One consequence of this crisis will be that people will say we really have to overhaul these institutions.

What is happening to the commodity markets and food prices?

There have been some curious market interventions. Subsidies to produce bio-fuels in the US have diverted corn production to oils. There are some very peculiar goings on in commodity markets. The root of the problem is misguided government interventions.

The yuan is appreciating; Singapore, for instance, is pursuing a strong currency policy to combat inflation. What are the implications amid the current slowdown?

Depreciation of the US dollar is serving to offset recessionary pressures in the US. That is welcome. Massive deflationary effect from the housing market is flowing to consumer spending. But you got some offset in the form of American manufacturing. US cars are being exported, for a change, after a long time. And the rest of the world should not seek to resist. That would perpetuate global imbalances.

Since last year or so the Chinese have been behaving statesman-like. It's no coincidence that the renminbi started moving when Americans stopped shouting about it. All this is generally beneficial. Any sharp currency movements, however, will cause casualties. But generally the movements have been quite positive. Of course one has to watch the inflationary consequences of these moves. But given the economy is slowing globally, inflation should not be a worry. Manufacturers will get a nasty surprise if they tend to raise prices now.