Rob B.
Program Manager – IT Governance, Regulatory Compliance, and Controls at ActiveHealth Management
Are the "brightest minds in finance"finally onto something?
From today's Wall Street Journal:
"Last week, The Wall Street Journal assembled roughly 100 of the brightest minds in finance to discuss not just how to restart the global financial system, but how to reconstruct it, so both the spectacular excesses and catastrophic failures of the past decade can be averted."
Here's what they came up with:
http://online.wsj.com/public/resources/documents/Recommendations.pdf
I have my own opinions about some, am formulating opinions about some others, and scratching my head about the rest. Discounting those filtered through thought-free ideological prisms, what are the best arguments for and against each one?
Clarification added March 30, 2009:
My favorites all deal with transparency, which Adam Smith talked about a lot more than the virtues of unregulated free markets. Number 13 TRANSPARENCY BEFORE REGULATION, seems to make the most sense of all. Here's what it says:
Systemic risk regulator should require all firms first to provide information. Regulation should be limited to those deemed to pose a systemic risk. Intermediaries with sufficiently long investor lock-ups and sufficiently low leverage relative to risk should be granted a safe harbor from regulation. Regulator should publicly disclose cross-industry liquidity and concentration risk.
Number 20, my second favorite, hits the issue of foreclosure reform head on.
The ones I am scratching my head about are those that seem purely tactical.
Good Answers (3)
Frank F.
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To help others address this issue, I am copying the PDF file summarizing the Top 20 points being made by this group of 100 experts.
The first point to note is that these issues address the U.S. and *not* the global financial situation, which will have a variety of differences. And this agenda does not anyway address overriding global macro economic regulatory needs and coordination.
I basically agree that all of these proposals are needed. Indeed, I believe strongly that many of them should be much, much stronger in their intent. Some also seem to contradict each other.
But these shortcomings may be due to the summary nature of these issues. I don't have time to read the entire proposals in the long-form documentation. My own comments are in square brackets, inserted after each point of the Top 20 points. Please excuse me, if my comments do not take into account what is said in the full document. I only read the one-page PDF summary form.
=========================
Top 20 principles for rebuilding the financial system,
as developed by participants in Wall Street Journal's
"Future of Finance Initiative".
Full Coverage:
http://online.wsj.com/public/page/future-of-finance.html
PDF File of Top 20 Points:
http://online.wsj.com/public/resources/documents/Recommendations.pdf
=======================
1. STRENGTHEN UNDERWRITING STANDARDS
Bank management and bank examiners must enforce the banks’ minimum underwriting standards, focused on the borrowers’ ability to repay debt from income. Extend supervisors’ authority beyond banks to mortgage brokers and other bank agents. Ensure national real-estate appraisal standards.
[FF: This is a no-brainer. There are well-established metrics for lending money, which any prudent lender ought to follow. It ought not to need regulation, but apparently lenders cannot be trusted to be prudent, and their own credit supervisors, risk monitors, and internal auditors are obviously not up to the task. So regulation becomes necessary to prevent absurd and reckless lending.]
2. BOLSTER F.D.I.C.
Bolster the Federal Deposit Insurance Corp. and provide it with additional funds and flexibility so there is capacity to handle escalating bank failures.
[FF: In the normal course, this should not be necessary. I see this mainly as a measure to restore confidence and to allow FDIC to clean up many messy banks, several of which could yet fail.]
3. REGULATORY OVERHAUL
Streamline the regulatory architecture so there is more effective and consistent regulation across financial services and an end to regulatory arbitrage. Improve effectiveness of regulators. Provide them with better training, pay, status and resources. Specific industry experience desirable. Testing,licensing and continuing education required.
[FF: This is absolutely required. But the regulators failed us in the current fiasco. So my question becomes, who oversees the Federal Reserve to ensure that the regulators are indeed strictly regulating?]
4. CREATE A NEW CLEARINGHOUSE
Create a clearinghouse to enhance transparency for standardized credit-default-swap contracts, including individual corporate names and indexes. The clearinghouse would also extend to overnight financing and interest-rate swaps.
[FF: Yes, this is absolutely required to create a record of derivative dealings. Indeed, I would go farther, and ban any and all kinds of derivatives entirely. They are what caused the problem. They are instruments created by lunatics and traded by madmen who have no clue as to their value, because none can in fact be derived.]
(continued)
Links:
- http://online.wsj.com/public/page/future-of-finance.html
- http://online.wsj.com/public/resources/documents/Recommendations.pdf
Clarification added March 30, 2009:
(continued)
5. RAISE CAPITAL REQUIREMENTS
Writers of credit-default swaps should face higher capital (reserve or margin) requirements. Banks heavily involved in the CDS market should face a further surcharge for concentration risk.
[FF: gain, if derivatives are to be allowed, then I would make the reserve or margin requirement prohibitive. The problem with this proposal is that it will encourage greed-driven inventors of financial instruments to find yet new ways to leverage these lunatic instruments, causing even greater problems than still exist in financial markets.]
6. ENHANCE COLLATERAL
Enhance collateral requirements on over-the-counter derivatives to protect the system. To minimize the effects of financial-institution failure, regulators should segregate customer collateral in the event of a bankruptcy by a firm involved in the credit-default-swap market.
[FF: Again, this is a pathetic band-aid to try to resolve a cancerous situation which should never have been allowed to exist in the first place. The cancer ought to be totally eradicated and these toxic derivatives removed from the system.]
7. SMARTER SECURITIZATION
Improve disclosure in securitization, improve underwriting standards, require all parties in the process to have “skin in the game.” Create meaningful standards for transparency of financial flows in all instruments, and make the information available in an easily accessed form.
[FF: Again, this goes without saying. But this is mainly a "motherhood" statement.]
8. RATING-AGENCY REFORM
Eliminate special status of rating agencies. Reform pay structure for rating agencies to align incentives better so they are paid over time as their ratings prove to be accurate.
[FF: Absolutely this is required. The rating agencies have totally failed in their responsibility. Though, in their defense, they could not value derivatives -- which cannot be valued by anyone.]
9. CONSISTENT REGULATORY SYSTEM
Include non-bank financial institutions under regulatory umbrella and require them to provide information to the systemic regulator. Regulation should be risk-based. Firm-specific information should be private, and only aggregate information made public.
[FF: All financial service firms should be under the same regulatory environment as a bank has typically been.]
10. CONSTRAIN LEVERAGE
Limit leverage across large, systemically important financial institutions, and enhance capital requirements for certain products. Be clear about how risk gets measured for purposes of leverage and capital requirements.
[FF: Again, this is covered by the above proposals on reserves and measurement of value and risk. It requires basic, centuries-old banking prudence.]
(continued)
Clarification added March 30, 2009:
(continued)
11. LET TARP CAPITAL BE REPAID
Make regulators explicitly state conditions for the repayment of money to the Troubled Asset Relief Program.
[FF: Fine, it is supposed to be repaid anyway, no?]
12. EXECUTIVE COMPENSATION
Limit the government role in executive compensation to companies where the government has a stake. Companies should be sure executive compensation provides the right set of incentives.
[FF: I disagree. There should be no bonus system whatsoever in the compensation structure pf the financial services sector. If it is allowed to continue, then all should be regulated, not just those where there is government funding/ownership. Compensation should be a regulatory issue, just as should interest-rate setting.]
13. TRANSPARENCY BEFORE REGULATION
Systemic risk regulator should require all firms first to provide information. Regulation should be limited to those deemed to pose a systemic risk. Intermediaries with sufficiently long investor lock-ups and sufficiently low leverage relative to risk should be granted a safe harbor from regulation. Regulator should publicly disclose cross-industry liquidity and concentration risk.
[FF: While we all agree we need transparency. That cannot preclude regulation. How is transparency to be demonstrated, to whom? The regulators must have authority to step into any institution and attest to transparency. This proposal is contradictory.]
14. PRICE AND VOLUME TRANSPARENCY
The industry should publish price and volume data on over-the-counter derivatives.
[FF: See other proposals and comments. This is all common sense.]
15. FED SHOULD BE SYSTEMIC RISK REGULATOR
The Federal Reserve should be the systemic risk regulator of non-bank financial institutions. It is important that the regulator be independent and apolitical. We recommend using private-sector advisory bodies. In order to take on these responsibilities, the Fed may have to reallocate some responsibilities to other agencies.
[FF: I disagree that private-sector advisory bodies should be used. The industry has proved itself unable to self-police its own members.]
(continued)
Clarification added March 30, 2009:
(continued)
16. ENSURE SUCCESS OF PUBLIC-PRIVATE PARTNERSHIPS
To improve the chances that the Public-Private Investment Program works, the government should recognize that many sellers of these assets are reluctant because of the impact on their balance sheet, and should allow for regulatory forbearance on capital requirements or accounting flexibility.
[FF: This is just a lobby-induced excuse to allow the government to bail out the industry further. I disagree that money should be pumped in to make it easier for private investors to come and play. On what basis is that to be determined, and by whom?]
17. ACCOUNTING RULES
Have a sensible set of accounting rules to reflect value for financial reporting and capital purposes.
[FF: Of course, but that is why we have accounting and auditing standards boards. External auditors need to follow the proper procedures and to cry foul on the violators. Audit Committees of Boards of Directors need to do the same.]
18. NEW RESOLUTION AUTHORITY FOR NON-BANKS
Create an FDIC-like model for winding down non-bank financial institutions that pose system risk. Adopt global standards for determining how different classes of creditors are treated.
[FF: Long overdue. Should have been implemented by Paulson last Fall.]
19. AUDITORS ENFORCE CONSISTENT MARKS
Encourage disclosure of disparate asset marks, by asking auditors to raise instances of price discrepancies among clients.
[FF: See above re accounting/auditing.]
20. LIMIT FORECLOSURES
More efforts to limit foreclosures through interest and principal reductions, rent-to-own and other creative solutions. Create a new federal agency with sufficient resources to limit foreclosures. Force banks to identify potential troubled borrowers.
[FF: This can only be a temporary solution to the current mortgage crisis. I personally disagree with it. Loans in default should be foreclosed upon. Temporary or minor relief is not going to work in 95% of the situations which still prevail, nor on new ones which occur daily.]
Hope that is helpful to the discussion. Sorry it was so long!
Cheers! Frank
Clarification added March 30, 2009:
I also added the hot links.
==========================
FRANK FEATHER
Global Business Futurist and ex-Banker
~~ "A Future You Can Bank On!" ~~
Website: http://FFeather.com
e-Mail: Frank.Feather@Gmail.com
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Lynn W.
virtualization since Jan68, online at home since Mar70
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A repeated theme in the Madoff hearing by the person trying for a decade to get SEC to do something about Madoff, was that while new legislation and regulation was required, it was much more important to have transparency and visibility; crooks are inventive and will always be ahead of regulation.
however ...
The Quiet Coup
http://www.theatlantic.com/doc/200905/imf-advice
from above:
But there's a deeper and more disturbing similarity: elite business interests -- financiers, in the case of the U.S. -- played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive. The government seems helpless, or unwilling, to act against them.
... snip ...
The DNA of Corruption
http://www.d-n-i.net/dni/2009/03/29/the-dna-of-corruption/
from above:
While the scale of venality of Wall Street dwarfs that of the Pentagon's, I submit that many of the central qualities shaping America's Defense Meltdown (an important new book with this title, also written by insiders, can be found here) can be found in Simon Johnson's exegesis of America's even more profound Financial Meltdown.
... snip ..
... and related to above ...
Mark-to-Market Lobby Buoys Bank Profits 20% as FASB May Say Yes
http://www.bloomberg.com/apps/news?pid=20601109&sid=awSxPMGzDW38&refer=home
Officials at Norwalk, Connecticut-based FASB were under "tremendous pressure" and "more or less eviscerated mark-to-market accounting," said Robert Willens, a former managing director at Lehman Brothers Holdings Inc. who runs his own tax and accounting advisory firm in New York. "I'd say there was a pretty close cause and effect."
... snip ...
Now-needy FDIC collected little in premiums
http://www.boston.com/news/nation/washington/articles/2009/03/11/now_needy_fdic_collected_little_in_premiums/
from above:
The federal agency that insures bank deposits, which is asking for emergency powers to borrow up to $500 billion to take over failed banks, is facing a potential major shortfall in part because it collected no insurance premiums from most banks from 1996 to 2006.
... snip ...
Clarification added March 31, 2009:
with respect to taxes, there was roundtable of "leading expert" economists last summer about current economic mess. their solution was "flat rate" tax. the justification was:
1) eliminates possibly majority of graft & corruption in washington that is related to current tax code structure, lobbying and special interests
2) picks up 3-5% productivity in GNP. current 65,000 page taxcode is reduced to 600 pages ... that frees up huge amount of people-hrs in lost productivity involved in dealing directly with the taxcode as well as lost productivity because of non-optimal business decisions.
their bottom line was that it probably would only be temporary before the special interests reestablish the current pervasive atmosphere of graft & corruption.
a semi-humorous comment was that a special interest that has lobbied against such a change has been Ireland ... supposedly because some number of US operations have been motivated to move to Ireland because of their much simpler business environment.
with respect to feedback processes ... I had done a lot with dynamic adaptive (feedback) control algorithms as an undergraduate in the 60s ... which was used in some products shipped in the 70s & 80s. In the early 80s, I had a chance to meet John Boyd and sponsor his briefings. I found quite a bit of affinity to John's OODA-loop concept (observe, orient, decide, act) that is now starting to be taught in some MBA programs.
Clarification added April 1, 2009:
last fall, congressional hearings into rating agencies and toxic CDOs, it was stated that in the early 70s, the rating agencies business process became "mis-aligned" when they changed from the buyers paying for the ratings to the issuers/sellers paying for the ratings (and creating opportunity for conflict of interest). several times in the hearings it was stated that both the rating agencies and the issuer/sellers knew that the toxic CDOs weren't worth the triple-A ratings but the rating agencies were being paid for the triple-A ratings.
then in late january, there was some news items that the gov. was using IDC to help evaluate the banking industry toxic assets (largely made up of these triple-A rated toxic CDOs).
Bank's Hidden Junk Menaces $1 Trillion Purge
http://www.bloomberg.com/apps/news?pid=20601039&sid=akv_p6LBNIdw&refer=home
from above:
So investors betting for quick solutions to the financial crisis could be disappointed. The tangled web that banks wove over the years will take a long time to undo.
At the end of 2008, for example, off-balance-sheet assets at just the four biggest U.S. banks -- Bank of America Corp., Citigroup Inc., JPMorgan Chase & Co. and Wells Fargo & Co. -- were about $5.2 trillion, according to their 2008 annual filings.
... snip ...
about the time the rating agencies' business process became mis-aligned in the early 70s, IDC bought the "pricing services" division from one of the rating agencies. disclaimer: i interviewed with IDC in the late 60s ... but didn't join them.
in any case, there were numerous comments that regulation is significantly simpler when the business processes are "aligned" (i.e. people incented to do the right thing) ... conversely, regulation becames significantly more difficult when the business processes are "mis-aligned" (people are incented to do the wrong thing).
the related comments from the Madoff hearings (again by the person that had tried for a decade to get SEC to do something about Madoff) was that crooks and fraud thrive where there is lack of transparency and visibility (transparency and visibility also mitigates the amount of regulation that is required).
we had been called in to consult with a small client/server company that wanted to do payments on their server; they also had invented this technology called "SSL" they wanted to use; the result is now frequently referred to as "electronic commerce". Somewhat as result, in the mid-90s we were asked to participat in the x9a10 financial standard working group which had been given the requirement to preserve the integrity of the financial infrastructure for all retail payments. The result of that was the x9.59 financial transaction standard ...some refs:
http://www.garlic.com/~lynn/x959.html#x959
Possibly because of the x9.59 work, we were asked in to NSCC (since merged with DTC to become DTCC) to look at adding similar integrity to all trader operations. Relatively quickly the effort was suspended because a side-effect of the work would have significantly improved transparency and visibility which supposedly runs counter to fundamental trader culture.
Phil P.
Owner, Catskill Technology Services, LLC
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One of the biggest problems at all levels of economics is the lack of negative feedback loops, and an excess of positive feedback loops. For those not familiar with Control Theory, a negative feedback loop acts to stabilize a system by opposing excursions outside the chosen range, while a positive feedback loop feeds on itself to go wildly out of control (can you say "bubble"?).
To some extent, the Fed Open Market Committee, in setting certain key interest rates, is a negative feedback loop. However, it changes too slowly, is unpredictable in its actions, and is too politicized. In addition, interest rates are too broad and crudely targeted a weapon. Witness the easy money availability post-9/11, which was meant to spur the overall economy, but ended up inflating the housing bubble. What we need is some "automated" system to change "something" (such as interest rates for narrowly targeted areas) quickly, predictably, and free from political interference. Policymakers would set goals (tweak system settings from time to time), but not mess with the mechanisms.
That said, I have no idea how to implement something like that. Any thoughts or observations?
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Max J. P.
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Seriously, if that is all the 100 best heads could come up with I am not surprised we are in a crisis. This proposal only requests more regulation but hardly defines what needs to be regulated and how. What happened to the idea of free markets?
One point is not mentioned at all and that shows that truly large corporations AND government (left or right - democrat or conservative) are in bed together and up to no good. No, I am not a conspiracy buff at all, because we are way beyond theory. It is out in the open and I am amazed that no one is screaming, which is scary.
It seems forgotten now that the economy is a complex adaptive system (Adam Smith's Invisible Hand) that takes care of itself. More regulation will just make things worse and not better. The cost of compliance is already staggering and businesses will spend less time and money to compete but more to comply.
What is completely missing as a proposal is to finally enforce (when it should propose enhancing) monopoly principles. If a business is too large to fail then it is a monopoly or it has at least a similar effect on the economy, meaning that it distorts free markets. The main problem that the financial system faces is its interdependence of financial institutions that no one can manage by means of financial instruments that no one understands. Large businesses are no more than inept bureaucracies. If we would have free markets then these large unmanageable behemoths and dinosaurs would now go under making room for the agile mammals to crawl from the sea and develop legs. But I agree, that the cost of it would be dramatic. Let me however warn you that it still might happen because all the activities right now are not solving the problems they are just prolonging them.
Rather than regulation of operation, free markets would just need a few simple principles such as limiting business size in terms of revenue. How? Very simple, just use progressive taxation. While you are at it do away with taxation on small businesses or offset corporate tax by the income tax that its employees pay. You will see employment and as a consequence the markets flourish. What do we do now? We tax wealthy individuals who own agile, small businesses more to prop up the large and inept ones that we now regulate even more. How should that work!
If you are now preparing to pounce on me that taxation is bad for the economy you should go back and read your economy textbooks. Regulation is bad but taxation is a necessity. Milton Friedman's 'Freedom and Capitalism' is as valid as it was 40 years ago.
Anyway, why is no one taking away the Nobel Prize of Mr. Black and Mr. Scholes of future utility model fame. Their blind assumptions are as much responsible for the mess as are those who gave them the prize.
