Another FT Special Report on Risk Management in Finance that did not mention the risk of regulations

Sir, you publish a special report titled “Risk Management: Finance” March 22. In it not once do you refer to the fact that the current supreme financial risk managers of the world are the banking supervisors in the Basel Committee, and who so arrogantly assume it is their right to set Ground Zero for the rest of the risk managers.

With their risk-weights in Basel II, these inept nuts, and there really is no other word for them, decided that the banks returns on capital could be dramatically increased, by allowing leverages of more than 60 to 1, as long as they kept doing operations related to an officially confirmed no risk situation, a triple A credit rating.

Paul Davies explains “why there is now a greater understanding that there is little guidance to be found from the past when preparing for the future”. But that is only so because most still refuse to look at the recent past, and understand from it than bank regulators cannot discriminate as they did, and do, by means of capital requirements for banks based on perceived risks, without creating monstrous systemic risk.

Brooke Masters writes “now that regulators have moved to impose tougher capital and liquidity requirements, attention is turning to other systemic risk”, which ignores that it was not the lack of toughness of the capital requirements that mostly caused the disaster but the way how they discriminated. What better evidence is there that the 8 per cent capital requirement in Basel II for what is rated BBB+ to BB- has proven more than sufficient and that it is only in the area covered with AAA to A ratings where problems have surged.

Richard Milne writes “Follow the line of debt to spot the coming crisis” and refers to a possible bubble in the public sector, while not saying one word about the fact that banks can lend to the public sector with infinitesimal capital requirements, as long as these sovereigns are rated AAA to A.

But worst of all, the special report again fails to mention the fact that the market’s risk management already clears for perceived risk of default, which includes of course the credit ratings, by means of deciding the risk premiums to be charged in each case, and making all the alternatives investments equal. And so that when the regulators then come and intrusively layer on their own risk biases on the banks, the only thing they are doing is distorting the financial markets, and becoming themselves the greatest source of systemic risk.

Hey, you missed the story!

Sir, "Moody's error gave top ratings to debt products" May 21, is presented as a "human bites a dog" story even though it really is a "dog bytes a human" event. We all know that Moody and all the others are bound to commit errors, it is only human and must be forgivable, just as then try to cover up those errors is also human though not as forgivable.

The real story is how these agencies could have been regarded as infallible by the regulators who empowered them, and thereby forcefully or suggestively induced the market to blindly follow their ratings.

The article states "Credit ratings are hugely important within the financial system because many investors – such as pension funds, insurance companies and banks – use them as a yardstick to restrict the kinds of products they buy, or to decide how much capital they need to hold against them" and this gives the impression that the use or not of the credit ratings is a voluntary issue, which is clearly wrong. The investors mentioned, use the credit ratings because they have been strictly ordered to do so by their respective regulators.

Now if they managed to get you to spin a story about a once in a lifetime crazy mistake event that is never ever to happen again, then let me assure you that someone is shamelessly using you.

Stop them from digging!

Sir, Paul Davies and Gillian Tett in “Moody’s talks of rating reform”, September 18 quote Brian Clarkson, the President and chief operating officer of Moody’s saying “One of the issues we are talking to regulators about is the possibility of creating tools to address liquidity and market issues”. 

And we can just pray for that the regulators understand the real meaning of “when in a hole, stop digging”.

Once again, I do not have anything against the credit rating agencies refining and improving their mostly already very good products. What I oppose though is that the regulators press the market to use these products, since such a bias will only guarantee the introduction of even more severe systemic risks than those that we have been discovering lately with the sub-primely awarded mortgages to subprime borrowers.

Why we should beware of the use of credit rating agencies even if they are superb

Sir, by now you must know that I am one of those who have been most sceptical about the growing role that has been assigned to the credit rating agencies in channelling the financial flows of the world, which is why I commend the financial team of FT for their Failing Grades?, May 17. But, having said that let me briefly give you an example why I think we are on the wrong track even if these agencies were superbly and almost inhuman efficient in their work.

As my MBA, though not that rusty, is from 1974, pre Black-Scholes-Merton model days, I am currently trying to update it by taking the exams for a Certified Financial Advisor (CFA) in the USA, surrounded by thousands of much younger candidates. It is not easy and so that you can better understand how hard it really is, just look at the following question that appears in a CFA mock exam:

Explain whether you agree or disagree with the following statement: “The credit risk of a bond is the risk that the issuer will fail to meet its obligation to make timely payments of interest and principle”

If I had answered the above with a YES, as anyone would have intuitively done, had they not peeked in on the updates, I would have distanced myself further from my CFA certification since the right answer indicated is a “NO”, among others because the (modern) credit risk now includes a “Downgrade risk, which is the risk that an issue will be downgraded by a rating agency”

And so now, instead of having to focus on the true object of the credit risk, we must also focus on the side issue of the opinions of the credit rating agencies, and that Sir, though we might feel all cosily comforted by more knowledge, does not really seem to put the world on a wiser financial track.

I do not mind credit rating agencies but, if we are forced by financial regulators to go by their criteria, then they should be forced to be equally responsible for them. Alternatively, let them hang around, giving their First Amendment protected opinions, but do not force anyone to have to follow them.

We need some new derivatives!

Sir, Paul J Davies reports that Moody’s warns on change of control clause”, April 26, with respect to a clause that is supposed to protect the investor from the risk that a company suddenly gets swallowed up in a highly leveraged takeover and leaves him with a much riskier investment that he had originally intended. As it seems some of these clauses when the credit rating agencies downgrade the company but, if the credit rating agency did, as it should, downgrade the company before the formalization of the takeover event then, as no further downgrading should be necessary, the investors could be left out in the cold. As I read it, this seems to be just another example of a derivative market that needs to be developed in order to cover the changes in credit rating methodology and timing of announcements applied by the credit rating agencies. And, after that, perhaps the only remaining risk we need to cover before we can sleep calm under our blissful protective cover, is the regulator risk but, come to think of it, there might not be pockets deep enough to guarantee the counterpart risk on that.