Managing Risk: TPPA Edition

The treaty document has been out for a couple of months now, and the treaty itself was signed last week. But there's still plenty of opposition to the pact, as we will have another couple of years two go under the ratification process - yup, it still isn't a treaty we have to abide by yet.

In any case, some of that opposition is getting a bit shrill, repeating nostrums that don't really apply any more. Part of the problem is the sheer length of the treaty document; another is the legalese language used.

Take ISDS for example. There seems to be this notion that ISDS would override the ability of governments to regulate, including matters of national interest such as labour laws, health and the environment. That's not true.

Incentives Matter: Insurance, Banking and Performance Based Pay

One of the causes identified for the meltdown in the US property securitisation market – those CDOs, CDOs squared and the CDSs used to back them up – is that even when it was obvious that the US housing market was in trouble, commercial banks continued pushing for higher originations, and investment banks kept pushing out synthetic products to securitise them.

And the reason for that was simply because pay was tied to performance, which in this case involved pushing product out the door, whether or not it was in the long term interests of the employees and the financial firms doing the pushing, much less the investors doing the buying. As Charles Prince of Citi put it, “…as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”

The Good and Bad of Financial Liberalisation

For full details read the press release from BNM:

"The liberalisation measures announced today aims to strengthen Malaysia 's economic interlinkages with other economies and enhancing the role of the financial sector as a key enabler and catalyst of economic growth. These liberalisation measures are consistent with the objectives committed under the Financial Sector Master Plan (FSMP) issued in 2001 to develop a resilient, diversified and efficient financial sector. More than 90% of the FSMP initiatives have been completed or are being implemented on an ongoing basis."

The operational measures are fairly minor, except for insurance and takaful companies which will now be allowed to open branches without limit, and onshoring of qualified offshore FIs. The other two categories are more interesting however: BNM is offering two new Islamic banking licenses (subject to a minimum capital base of USD1 billion), five new commercial banking licenses, and two additional takaful licenses. Foreign equity limits have also been raised to 70% for all institutions except for the depository banks, and potentially higher for insurance operators.

My first instinct as an economist is this is all good - the more competition, the greater should be the efficiency of the banking system, and the greater should be the impact on social welfare. It's also clear that BNM is pushing for the continued development of Malaysia as the centre for Islamic banking and takaful.

However, the pragmatist in me wonders what having all this additional capital pumped into the banking system will do to credit creation (I'm not familiar enough with the insurance sector to make a stab at commenting on the impact). Right now banks aren't lending enough and creating more competition won't necessarily reduce the headwinds against additional lending. On the other, if and when the economy recovers (i.e. when these new banks start business), that's additional capital looking for a source of yield in an already crowded local market.

It would be interesting to see what will happen. These new banks could conceivably cannibalize business (deposits and lending) from existing players, in which case we get the efficiency and welfare gains that we're looking for. If on the other hand they add on to existing business (in other words, if they have to resort to wholesale funding), then we have an increase in systemic risk and the potential for a credit boom-bust cycle.

Assuming the five CBs have a capital base of USD500 million each, adding the USD2 billion from the new Islamic banks gives a total of USD4.5 billion as core capital. Assuming an average of 13% RWCR, and that core capital is half that, that implies additional credit of USD72 billion, or about RM250 billion, which represents a third of current total loans.

If all that goes in as additional lending locally - we are in deep doodoo. In practice, some of it would be cannibalization, some of it additional lending, and some of it is going overseas. The crucial question from the point of view of systemic risk is, how much will be in which category?

Update:
Conditions for the new licenses have been released for commercial banks and for Islamic banks and takaful operators. The capital requirements for the new banking licenses were a lot more modest than I expected at only RM300 million as against the USD500 million in my example. That totals up to about USD2.4 billion in additional capital, which at a core capital leverage ratio of 16 adds up to about USD40 billion in potential additional credit or about RM140 billion. That's equivalent to something like only 19% of current loans outstanding, which reduces the potential for a boom-bust credit cycle.

The Labuan offshore liberalisation conditions are available here (warning: pdf link). This doesn't actually amount to much - essentially the only change is having your physical back-office located in KL rather than Labuan. The benefits are obviously better access to customers and human resources, but it appears nothing fundamental has really changed.