Sunday, 24 July 2011

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.


  1. I think the biggest problem is too much money chasing too little return. Due to currency manipulation the Island is awash in invest-able funds that need to go some place. Banks are just one part, think how much the investment arms of insurance companies are investing. I knew a guy who had to loan billions every year and he had several other guys who had to do the same thing. Then there are the huge number of pawnshops lending money.

    Then we get into the politically directed lending such as DRAM and LCD TVs. Thanks to Taiwan and S. Korea we can all enjoy these wonderful things for often less than it should cost us thanks to generous govt directed subsidies.

    Then there are the glacial giant state-owned banks with their usual horrible service and over-staffed offices.

  2. "Banks are just one part, think how much the investment arms of insurance companies are investing."

    I don't know, but it's a pertinent question. The insurance giants hold a lot of land - especially in and around Taipei, or so I've been told.

    "Then there are the huge number of pawnshops lending money."

    Surely that won't add up to much though? What are they lending out - a few tens of thousands per customer at most? Also, many if not most of those pawnshops are run by the local "temple associations", whose financing may not be, ahem, entirely traceable through the banking system.

    Actually, one of the small things which amazes me about the treatment of money in Taiwan is the amounts that local residents "donate" to the construction of enormous new neighbourhood temples. Just outside the new temples, they put up displays listing the donors names and how much they donated. My suspicion is that it is a subtle form of protection money.

    Some of these things dwarf the houses they sit next to and there are so many of them that it's basically a five minute walk between them. Sinking hundreds of thousands of NT$ into a temple certainly wouldn't be my idea of a productive investment, "protection" money or not.

  3. My point is simply that there isn't a good credit scoring system along with loads of investable cash and multiple sources of lending. Almost every Taiwanese person I know is invested in some insurance scheme. That money has to go somewhere to make the return needed.

    I'd say pawnshops loan out millions. I see too many of them on TV for them not to be lending out some serious cash and making a good ROI.

    I think for temple donations you are seriously underestimating face and religious belief. While organized crime does benefit enormously from the temple association, some people have too much money, too much religious belief and the temples do help out the poor in my neighborhood.

    I wonder if there are any anthropological papers on the reasons behind temple donations.

  4. "My point is simply that there isn't a good credit scoring system along with loads of investable cash and multiple sources of lending."

    Yes - to expect a good credit scoring system under loan-or-die conditions is... a bit much really.

    OK, I'll bow to your superior knowledge on pawn shops since I seldom watch the telly.

    "I think for temple donations you are seriously underestimating face and religious belief."

    Wouldn't be the first time!


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