Northern Rock is back in the press. The EU commission has given the green light to restructure Northern Rock and remove the impaired assets from its balance sheet. This is window dressing: if impaired assets are marked to market and losses are realized, then the assets are on par with all the other assets. They then have a fair chance to perform better or worse than the other assets. If losses are realized, there is no good or bad bank and a combined bank is just as good as two separate banks.
The regulators should focus on the real issues:
Credit agreements, loans, etc. are highly complex legal agreements. The in-transparency of 200 page legal contracts does not gibe as well with quantitative modeling as we would expect it to in the 21st century. We need a computer language to code legal agreements. The advantage of this approach is that risk models can be used to accurately model the true risk: today, this is not the case, important information is hidden in complex legal talk and obscure contract appendixes of Excel spread sheets.
Even today, two years after the onset of the sub prime crisis, banks do not know which assets are included in their loan portfolios. They cannot access a Google map with an overview of the locations of the properties in their loan portfolios.
Second, the fixed income markets are illiquid and their pricing is spurious, where minor events can cause major dislocations of price levels. We need to acknowledge this deficiency and take preemptive measures. Credit markets need to become highly liquid over the counter markets with real time delivery and second by second interest rate payments. Second by second interest payments will make it possible for markets to respond to the smallest disequilibrium. Furthermore, it is necessary to nurture investment strategies that are stabilizing, where professional fixed income managers operate quantitative investment strategies that provide intra-day liquidity: whenever there is a short-term imbalance, they will take the other side and help bring demand and supply back in line and stabilize prices.
Liquidity and price stability in the fixed income markets is the sine qua non for a market economy. We first have to understand this problem and raise awareness for the issue before we can hope for corrective measures.
Author: Richard B. Olsen, Founder and CEO of Olsen Ltd