Wednesday, November 30, 2022

‘Repeal of key finance law could lead to greatest recession in history’

The memory is still very fresh and will forever remain vivid in the minds of most. For the first time in its history, Jwaneng diamond mine (which is Botswana’s real cash cow) stopped production because of severe depression in the market. Then followed the bleakest phase in the economic history of modern Botswana. Some nine years later, the situation has improved significantly but the new United States president, Donald Trump, could dramatically reverse it if he succeeds in his effort to have Congress repeal a piece of legislation that was designed specifically to prevent a 2008-like recession. On February 3, Trump signed an executive order titled “Core Principles for Regulating the United States Financial System” through which he sets in motion a plan to scale back the provisions of Dodd-Frank Act.Named after retired Senators Barney Frank and Chris Dodd, the bipartisan Act ÔÇöwhich is formally called the DoddÔÇôFrank Wall Street Reform and Consumer Protection Act ÔÇöcreated more stringent rules regarding the amount of money that banks must have on hand, increasing compliance and reporting standards for banks, introducing stricter mortgage requirements, creating the Financial Stability Oversight Council and the Consumer Financial Protection Bureau (CFPB), and curbing excessive risk-taking and the existence of “too-big-to-fail” institutions on Wall Street. The Great Recession ÔÇô as some now refer to it ÔÇô was a series of ill-fated decision-making and opportunism by a slew of US financial institutions. The spending bubble burst in 2008 and the Dodd-Frank Act became theprincipal regulatory response to the ensuing financial crisis. President Trump has however, called the Act a “disaster” and with his executive order, has initiated process to repeal it through a legislature dominated by his party. US media quotes him as saying: “I have so many people, friends of mine, with nice businesses, they can’t borrow money, because the banks just won’t let them borrow because of the rules and regulations and Dodd-Frank.” As Ishmael Radikoko, a senior finance lecturer at the University of Botswana explains, part of Trump’s plan includes stopping the operation of the CFPB whose mandate is to protect investors from the abusive behavior of big financial institutions. Radikoko says that partial or complete overhaul of the Act will come as good news to the banking industry as well as investment management and insurance companies. The repeal guarantees an environment which, while less restrictive, would be very risky to investors. “These institutions have been worried and concerned by regulations. They are not profitable anymore because they are operating in an environment that doesn’t allow them to invest in financial products that can bring returns,” says Radikoko. “Banks are particularly concerned that their customer base has been squeezed and that that they don’t have enough capital due to the higher capital requirement rule. So, removing restriction on banks to advance mortgages to even risky and poor creditworthy customers means that we might be back to the 2008 situation where mortgages were issued out to clients who ultimately failed to pay.”  However, Radikoko doesn’t expect the situation to be similar to that of 2008 ÔÇô primarily because it would not be occasioned by a housing bubble and also because banks will be more cautious this time around when giving out loans. The danger he foresees is that is that over time as mortgage loan books grow, the probability for bad debts will also increase because of problem of adverse selection and to a lesser extent, moral hazard. He says that on account of higher capital requirement being relaxed, banks will have more money to lend out and more money to participate in the derivative markets. With investment companies looking to making capital gains from the resale of mortgage-backed securities – and being allowed to do so by law ÔÇô there will be inclination to restart trading in those securities even in large over-the-counter markets. “Once again this will cultivate a breeding ground for the possibility of default by these issuers, especially that they will have nothing to lose and a lot to gain when they fail to settle their obligations. On the other hand, since they will be no restrictions on trading with risky derivatives, insurance companies like AIG may start selling credit default swaps again to poor investors who are looking to hedge their positions,” says Radikoko referring to the American Insurance Group which went bankrupt as a result of selling risky derivative products to cover losses as it was contractually obliged. He adds that when defaults ensue, investors will turn to the insurers who may also be too broke to cover the losses. The result: “We will be back in recession. Insurance companies will be enticed into selling these credit default swaps because they will think banks will be more cautious this time and not sell risky loans. So basically, they will sell these derivative products thinking that there won’t be claims against them. If that does happen, we will be back in recession again.” Trump’s immediate predecessor, Barack Obama, saved the day with a $787 billion economic stimulus package whose goal was to spur consumer spending, save between 900 000 and 2.3 million jobs, instill confidence needed to boost economic growth as well as restore trust in the finance industry by limiting bonuses for senior executives in companies that received the American Recovery and Reinvestment Act money. Some, especially Obama’s political opponents, were viciously opposed to this bailout. Radikoko says that considering such opposition, he doesn’t think that there will be any bailout when Trump’s plan backfires. “The financial systems might experience a total collapse this time around and we might be heading to the greatest recession in history.  However, if we do get into a recession, it won’t be immediate but may be in five years’ time,” he offers. On account of an undiversified economy, Botswana was badly affected by the recession and Radikoko expects the same thing to happen in the event the worst-case scenario he outlines plays itself out. The reason he gives is that the national economy is still undiversified as it was back in 2008. “There are good intentions as has always been the case for the last 50 years in terms of coming up with ideas like diversifying into manufacturing, tourism and services but implementation is where the problem is. We are just talking but not doing. So, we are still susceptible to external shocks as was seen recently with a sluggish economy emanating from problems in commodity markets worldwide,” he says. Beyond diversifying the economy, Radikoko says there is need to expand the market that Botswana has already bagged. The benefit is that “if one of our largest consumers of diamonds – especially the US –  is in trouble, that means we will also be in trouble. However, when our markets are diversified, the impact may be minimal because we can still continue trading in the global markets.”


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