Thursday, April 3, 2008

Regulating Wall Street

The nineties and this decade were years of financial deregulation that sought to liberate financial institutions and their instruments from the shackles of regulators. The free hand given to financial regulators and the resultant wave of financial innovation saw the emergence of a number of exotic financial instruments with an alphabet soup of names and off-balance sheet entities that sought to purchase and sell risk.

The whole objective of all this financial engineering was the diversification of risk as wide and deep as possible, and increasing the liquidity available by a continous chain of onward lending through securitization of debt. In the process risk got disseminated into unknown terrain, where it became impossible to even locate, leave alone price risk. The versatile financial creatures called Structured Investment Vehicles (SIVs) even emerged as a convenient alibi for hiding risks.

The massive deregulation saw the proliferation of unhealthy practices like abusive loans by independent mortgage brokers; risky and opaque transactions by financial institutions; credit-rating decisions that turned out to be wildly optimistic; and the underwriting of loans by mortgage brokers that were often based on fraudulent or inaccurate information.

The wave of deregulation climaxed with the bursting of the bubble in sub-prime mortgage backed securities. A series of other asset backed securities followed suit - Collateralized Debt (and Loan) Obligations, and Credit Default Swaps. Wall Street Banks, hedge funds, and insurers all ran into crisis as margin calls induced forced sell offs to cover losses.

Now there have been growing calls for tightening supervision of the risk-management practices of Wall Street investment banks and perhaps requiring them to keep higher cash reserves as a cushion against unexpected trading losses. This school of thought demands the same tight regulation that banks had for decades to be extended to Wall Street firms. There have been calls for setting up a regulator to re-examine capital reserves, risk-management practices and consumer protection without regard to whether companies were commercial banks, investment banks or nonbank mortgage lenders.

The actions of the Fed in recent weeks, in its capacity as lender of last resort, may have unleashed powerful moral hazard factors. The Fed had offered a $30 billion credit line to JPMorgan Chase to help it take over failing Bear Stearns, and also announced the opening up of its "discount window" - an emergency loan program that had been reserved strictly for commercial bank - lending to big investment banks. The later is an effective acknowledgement of the blurring of lines between Wall Street banks and commercial banks.

Commercial banks submit to greater regulation, partly in exchange for the privilege of being able to borrow from the Fed’s discount window. But with the throwing open of the "discount window", Wall Street firms were getting the same protection without subjecting themselves to additional scrutiny. As Roger Lowenstein writes in the Times, "Since the bank runs of the 1930s, federal protection of retail depositor institutions has been a hallmark of American capitalism. The Federal Reserve, in a sweeping extension, has now extended the privilege to gilt-edged investment firms."

The opponents have the usual explanations - higher cash reserves will dry up the liquidity available for lending, trading and underwriting new securities; tighter regulation will inhibit financial innovation, and so on. As the events of recent months have amply demonstrated, this is something akin to arguing for more of the deregulated environment that was instrumental in promoting moral hazard, greed, recklessness, all of which inflicted so much damage.

Paul Krugman has this excellent reminder of what lessons we should have, but did not, learnt from the Great Depression. He feels that Wall Street chafed at regulations that limited risk, but also limited potential profits and created a “shadow banking system” that relied on complex financial arrangements to bypass regulations designed to ensure that banking was safe.

He writes, "For example, in the old system, savers had federally insured deposits in tightly regulated savings banks, and banks used that money to make home loans. Over time, however, this was partly replaced by a system in which savers put their money in funds that bought asset-backed commercial paper from special investment vehicles that bought collateralized debt obligations created from securitized mortgages — with nary a regulator in sight.

As the years went by, the shadow banking system took over more and more of the banking business, because the unregulated players in this system seemed to offer better deals than conventional banks. Meanwhile, those who worried about the fact that this brave new world of finance lacked a safety net were dismissed as hopelessly old-fashioned."

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