Credit Risk Comprehension: Signal Or Noise?

Does one of the editors at the Taipei Times still actually read my letters? I was beginning to have the impression that they were automatically marked as spam, and that, as I am either banned from or unwelcome at nearly every other joint in the Taiwan blogosphere, my pariah status was fast nearing completion.

"The Financial Supervisory Commission’s (FSC) warning last week that it might consider asking banks to increase loan provisions to cover potential bad debts — after seeing some banks charge interest rates that are too low for unprofitable companies — revealed how domestic lenders have lost sight of a very basic requirement in this line of business: risk evaluation."

I'm not familiar with the details of bank regulation in Taiwan (perhaps I should become so) but I would imagine that risk evaluation processes themselves are either already directly subject to regulation or to the indirect pressures of other regulations. In any case, with the long term low interest rate policy of the central bank and the sheer number of commercial banks in Taiwan (more than fifty), competition to secure even the most dodgy of "assets" would surely be rife whatever the FSC did. Given just these two conditions, I do not see how the FSC's warning can be taken seriously. A more plausible solution would be to withdraw State "investment" from the large banks in complement to central bank interest rate hikes. This would have the effect of prizing open the banking industry to greater market pressure and thus eliminate many of the banks and the various overstretched State "services" and businesses that depend on them. Of course this is precisely why even a soft, moderate reform like this will be rejected out of hand.

"...the commission said it would examine whether it should raise the provision ratios on corporate loans and syndicated loans for banks. If banks continue to neglect the importance of credit risks in corporate loans, the commission might then consider imposing fines or withholding approval for a bank’s application to set up branches overseas..."

The fines will be dished out to the smaller banks and the overseas (i.e. China) branch application withholdings will be imposed on the larger banks like Fubon. The ensuing credit risk evaluations by the banks will be fudged to get around these problems. Is the FSC really prepared to go into the details for all of these loans and crack the whip without fear or favour? I doubt it.

"If there is one thing most people know about banks, it is that they depend on a certain level of trust from the general public. Simply put, banks take money from depositors; they then lend the money to others and make investments to make a profit for themselves, while paying interest to depositors.

In other words, with depositors trusting that they can recover the full value of their deposits at any time and under the expectation that banks will honor their contractual obligations, depositors are willing to put their hard-earned cash into bank accounts, allowing banks to use that money to support a functioning economy."

That's a rough description of the fractional reserve system, but it is flawed on two counts: first and most importantly, the presumption that depositors "trust" a bank is not quite right since this ignores the necessary distinction between savings deposits and demand deposits. In respect of demand deposits, the depositor typically has no choice on whether to deposit his cash with a commercial bank or not, since he is required to do so in order to comply with government regulations imposed for purposes of tracking money laundering and tax evasion. Yet these demand deposits are also accounted in the commercial bank's lending. So it is not that the depositors are "willing to put their hard-earned cash into bank accounts", it is that they have to do so or risk breaking the law. The second flaw in this description is that it ignores the reserve ratio and therefore the scale at which this operation is performed - in Taiwan I believe it is 8%, which is to say that of total deposits, a bank need only keep 8% in reserve to satisfy demand withdrawal.

"However, what if one day depositors begin to suspect that banks might not meet their obligations because the banks did not use the funds wisely? Large losses and debt defaults could create panic among depositors and lead to bank runs and financial instability. While this is a worst-case scenario for the country’s banking system and is unlikely to occur any time soon, it is this failure by banks to engage in risk management that the financial regulator is so concerned about."

"Unlikely to occur any time soon"? I wouldn't be so sure - as the writer is surely even dimly aware himself, the current incentive structure (excess, protected competition and low interest rates) in which the banks operate pressures them into making bad loans and thus enabling capital malinvestment. The description is interesting because it seems to set up a future explanation of a banking run as a result of "greedy bankers", an explanation consonant with the Left's ignorological neglect of the critical import of the State's monetary, fiscal and regulatory policies in shaping this situation. However, the situation is potentially far worse than a mere bank run, since we must also take account of the inflationary pressure which the low interest rate policy of the central bank exerts over the NT$ dollar and the enormous government debt hanging over the entire economy. A government debt default would likely be averted by a policy of debt monetization, or "quantitative easing", i.e. having the central bank start purchasing the government's debt either through proxies or directly. A QE policy by Taiwan's central bank (with government debt at approximately 165% of nominal GDP) would create enormous inflationary potential, which is why the possibility of currency collapse ought to be taken seriously.

"Unfortunately, the commission’s request that banks solve this credit risk problem by setting reasonable lending rates is wishful thinking, because no one knows what reasonable levels of lending rates should be."

Yes! That is as true as it is critically salient: the only way in which "reasonable" levels of lending can be discovered is through the functional integrity of a price system in a banking market freed not only from government regulation, but from the currency monopoly of the central bank. That is the economic importance of profit and loss - they are the signals which enable the efficient coordination of resources - and it is vital to the "life" of an economy that they are not distorted.

"The truth is that as long as banks are swamped with excess liquidity, the rates will not go any higher. However, if reckless lending by banks only works to fuel over-investment and create bad debts — similar to what we have already seen in their lending to domestic DRAM companies — this behavior should be stopped immediately."

Yet it cannot be merely stopped on fiat whim unless the FSC is prepared to go so far as to actually start shutting down banks - the political-economic consequences of doing so would not be entertained by the sitting government for a moment.

See also my earlier brief post on Taiwan's banking system here.