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"I remember when Countries and Banks were AAA....."

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I am putting an age on myself. I remember when JPM was AAA. I remember when UBS was AAA. When 2 Dutch banks (ING and Rabo) were AAA. Those were the days.

What were those days though? And can we return, and do we want to?
Capital was husbanded in these institutions against all manner of financial catastrophes, none of which ever occured. Now this might be the tail wagging the dog - they were so well capitalized that their counterparties knew they would lose in any bet against them. So even if the bank might have been technically insolvent for a weekend, nobody dared risking a bet that would suggest they would not be trading by Monday.
The securitisation market changed all of this. The erstwhile monopoly that banks enjoyed - providers of credit and so the sole conduit by which money supply increased - was eroded as more and more market participants started to take financial liabilities, resturcture them in waterfall vehicles (RMBS, ABS, CDOs, CLOs etc), and create credit alongside the banks. This competition had the deisred effect. The cost of capital in the marketplace fell. I remember when I graduated Uni, and credit cards had a 22% rate. They went as low as 2-3%. Now my rate is (not sure) 7-8%. A risk premium, but decidedely cheaper than 22%.
It used to be that banks charged 22% because they could not lay off this risk. Fair enough. Rates jumped when the securitisation market collapsed in 2008. Banks had to keep more and more credit card recieveables on thier books, and the durations seemed to be getting longer and longer. However, in a normally functioning market, parts of your business make money, and parts lose. So in the credit card space, whereas banks used to enjoy a monoploy, there is now cut-throat competition. So one needs to walk the "risk plank" in order to make decent margins. At some point this becomes a game of chicken, plucking nickels from the highway. Apply this scenario to the whole business, and throw in a management culture that saw themselves as immune from the street-level brawling that investment bank traders engaged in, and you can see how these institutions were completely broadsided.

Should banks be AAA? Should they be required to hold enough capital to earn a grade that implies there is virtually no risk of failure? My opinion is no. There have been numerous benefits that have accrued to business and society from this "public" good being subject to market pressures. Its a risky business, and there are failures. The failure of management and regulators was driving by looking in the rear-view mirror. Few people attempt to anticipate where their business will be in the future, even those at the top. Just as when passing the football, you want to kick it to where the forward *will* be, not where he is now, so to do regualtors and managers need to invest in systems and structures to accommodate a world where securitization will be X times bigger, and disintermediation will have increased by Y percent. This (as it was 200 years ago) is the challenge.

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Guest Monday, 25 May 2020