Sunday, September 13, 2009

Financial market regulatory reforms - still-born?

Forget, health care reforms in the US, the much trumpeted makeover of the global financial markets appears set to die the "mother of all deaths"! How things have changed in the global financial market landscape over the past few weeks! From virtually begging for bailouts and accepting, albeit grudgingly, unprecedented conditions on among other things, executive compensation practices, Wall Street and their counterpart firms across the world, are now pulling out all the stops to prevent ceding ground on anything but cosmetic regulatory reforms. Lehman, AIG, Merrill Lynch and the rest appear to have been mere blips in the remorseless march of the financial markets.

After the tumultuous events of the past year, it was only natural to expect a radical restructuring of the global financial market architecture and tighter and more intrusive financial market regulations to prevent the recurrence of similar crises. But a year on, with green shoots sprouting in the economy and equity markets rising steeply, regulatory reforms are slipping to the backstage and business as usual appears to have set in. With the worst of the crisis blowing over (or so it appears), a golden opportunity to have in place an effective financial market regulatory architecture appears to have been missed.

As the Times reports, despite being "backstopped by huge federal guarantees, the biggest banks have restructured only around the edges". In the meantime, job losses have stopped, pay increases are back, executive compensation is set to reach greater heights, profits have been rising, and equity markets are soaring. As the Times writes, "For now, banks still sell and trade unregulated derivatives, despite their role in last fall’s chaos. Radical changes like pay caps or restrictions on bank size face overwhelming resistance. Even minor changes, like requiring banks to disclose more about the derivatives they own, are far from certain... legislation to force derivatives trading onto exchanges has stalled, and banks are still writing contracts with limited regulatory oversight."

As many people have argued, any failure to press ahead with reforms or settling for a weak and diluted set of reforms will unleash uncontrollable moral hazard concerns and invariably set the stage for an even bigger calamity in the years ahead. If major banks are allowed to keep making bets that are ultimately backed by taxpayer guarantees, they will return to the practices that led them to underwrite trillions of dollars in bad loans. All the recent cut backs on risky positions, reduction in leverage, and allocation of larger cushion against losses by Wall Street firms will be swept away in the inevitable wave of "irrational exuberance" that surrounds the next bubble. Further, as the Times quotes Nassim Nicholas Taleb who says that the extensive government support that began after Lehman collapsed will lead investors to assume that governments will always prevent major banks from collapsing.

In an excellent article Alan Blinder had traced the lack of much headway with financial reforms to - the feeling that it is "yesterday's problem", has been lost in the overcrowded legislative agenda, has been lobbied to death, and caught in bureaucratic infighting and turf wars. He prioritizes on atleast three sets of reforms - creation of a systemic risk regulator (which not only just watches risks develop and issues warnings, but is also empowered to take action), a new mechanism to euthanize or rehabilitate giant financial institutions whose failure could threaten the whole system, regulate and make transparent derivatives trading (by standardizing them and pushing their trades into clearinghouses or organized exchanges, where more capital would be required and collateral would have to be posted often).

Jeffry Frieden traces the resistance to change in financial markets to special-interest politics (regulatory agencies are often sympathetic to the industries they regulate, or "regulatory capture"), technical complexity (modern finance and its instruments are arcane and complex, and therefore beyond the comprehension of most consumers, lawmakers, bureaucrats and even regulators, all of whom depend on the financial institutions themselves to get information), fragmentation (separate regulations and regulators for each variety of bank - commercial banks, savings and loans, credit unions - and other financial institutions, enables them to "jurisdiction-shop" for the most favorable regulatory environment and also leads regulators to guard their turf), and uncertainty (new instruments are typically not well understood — indeed, they may have been devised precisely to avoid easy control by the regulators). He writes,

"For financial regulation to be reformed in line with the true public interest, then, requires an almost magical combination. Policymakers and regulators must be generally immune to political pressure from the financial services industries. Reformers have to have a broad and deep understanding of the great complexity of modern finance. Central policymakers need to be willing and able to override the opposition of existing, turf-protecting, state and federal regulators. And enough people have to care, and to be paying attention, to get politicians to focus on the topic and push it to a conclusion."

The Times also points to the work of Edward J Kane, who while arguing that tax payers must guard against the corrupting influence of bureaucratic self-interest among regulators and the political clout wielded by the large institutions they are supposed to police, calls for holding regulators accountable when they perform as poorly as they did in recent years.

The NYT has excellent graphics on how the Wall Street institutions first shrunk as the crisis deepened and are now growing back (market capitalization of the 29 biggest Wall Street firms fell from $1.87 trillion on October 9, 2007 to just $290 bn on March 9, 2009, and have risen to $947 bn on Sept 11, 2009); the status of the major players during the financial crisis; and the financial market crisis timeline over the past year. The Times also has this debate about why financial market reforms are getting stalled.

Update 1
See also this op-ed on the regulatory reform agenda. And President Obama's speech on financial market reforms, and responses here, here, here, here, here, and here.

Update 2
Economist Roundtable on financial market rgulation proposals here.

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