Financial Safety within the System: Current Status-Orange


Many people who read this site have financial assets whether they be bank deposits, stocks, or bonds.  In recent years, the financial industry has promoted the use of electronic deposits of stocks, bonds, and other instruments.  I am no longer confident that this method is safe from disruption.  I recommend that you take action now.  I recommend that you take possession of your stock/bond certificates.  If you have funds exceeding the FDIC limit within one bank, I also recommend that you distribute those funds among several banks to minimize possible exposure and disruption.  Keep some cash available, 1 to 2 months’ expenses if possible.

Recently, The Comptroller of the Currency in the U.S. approved the Basel II Capital Rule which specifically details capital requirement calculations of risk-based assets.  This "Rule" establishes the criteria for valuing risk-based assets that formerly had no regulation.  Without regulation, the financial institutions had no incentive to re-value a "junk" asset to market value. By keeping the original cost of the asset on the books rather than reducing the asset’s value based on market demand, the institution reports inflated asset valuations and correspondingly misrepresents their capital structure.  If you suffer a loss on the asset side, there is a corresponding reduction to the entity’s capital.  With less capital, the entity may not qualify to transact certain business that is reserved for the highest financially rated companies.

Ratings Agencies have been neglectful in analyzing those companies they classify.  Moody’s and other ratings agencies are the "watchdogs" of the financial arena.  Pension funds rely on ratings to determine what instruments they can invest in.  For instance, if Citibank issues "Commercial Paper" and has an investment rating of Aaa, a pension fund may be free to invest in the instrument.  However, if Citibank’s "Commercial Paper" grade is lowered to Ba1, Ba2, Ba3, etc. then the pension fund must divest itself of the investment.  A lowering of a company’s rating can have a dramatic, negative impact on its ability to borrow.  Also, if an institution has "off balance sheet" liabilities that would have an immediate and negative impact on its capital structure,  a pension fund could be investing in a "time bomb" and thus wipe out million’s of people’s retirement funds.  Enron was guilty of this type of scenario.  The ratings agencies were not oblivious of these "off balance sheet" investments.

What is Basel II?  (from Wikipedia) Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The purpose of Basel II is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face. Advocates of Basel II believe that such an international standard can help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse. In practice, Basel II attempts to accomplish this by setting up rigorous risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability.

If you read the Basel II Capital Rule, you may fall asleep.  Once awakened from your slumber you will realize that the financial world has become so complicated that the average person has no chance of understanding the financial condition (strength or weakness) of their bank.  Anytime you encounter complexity in financial transactions, watch out!  In an earlier posting I covered the topic of "real money".  Complexities increase as the liability of the instrument increases.

What will be the impact of the Base II Accord?  Ultimately it will force the financial industry to come clean with the over-valued securities contained within their balance sheets (or sitting outside their balance sheets, possibly as a footnote).  The capital structure of a bank dictates the amount of money it can lend.  If the capital of the bank is reduced by bad investments, the bank will have to contract its loans.  Existing loans may be called or not renewed.  This ultimately causes a contraction in the economic system.  "Fractional Banking Reserves" allows a bank to leverage its balance sheet.  On a positive note, additional deposits in the bank allow for a multiplying effect for lending capacity.  For instance, an additional $1,000 in customer deposits would allow the bank to create $5-10,000 in loans.  The capital of the bank is also considered in the loan expansion.  Removal of deposits and/or capital will cause a contraction in loans (and the ability to loan).

Why is all of this important to you?  If the banking system becomes weak, your deposited assets are at risk.  If an Internet stockbrokerage firm files bankruptcy, you could wait up to two years to receive your certificates (depending on the judge).  When there are prevailing winds of instability in the financial system, it is better to be safe than sorry.  Our risk level of financial meltdown is "orange".

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