Monday, February 9, 2009

Prescriptions for financial market reforms

Professors at New York University's Stern School of Business have come up with a collection of articles, to be published as a book, that seeks to analyze the causes and the way out of the deep economic crisis facing the global economy and financial markets. Summing up the findings in a Vox article, Viral Acharya and Mathew Richardson claim that the securitization cum diversification model failed to prevent the deep crisis because it sought to "arbitrage regulation than share risks with markets".

In order to capitalize on a surging market, banks set up a shadow banking system, through "special investment vehicles and conduits funded by asset-backed commercial paper that was guaranteed – often fully – by banks through liquidity and credit enhancements". This transfer of on-balance sheet loans and assets into off-balance sheet contingent liabilities created the fiction that risks were off-loaded from their balance sheets and they could move on with further lending, whereas the risks were firmly embedded within the banks themselves.

Incentives based on short-term gains and marked-to-market profits, rather than on long-term profitability of positions created, without any discounting for liquidity risk of asset-backed securities, connivance of rating agencies "more interested in fees than risk assessment" and the failure of regulatory oversight all contributed to the mess the financial markets face today.

They suggest four systemic changes to prevent such distortions in future
1. Change the incentives of traders and large profit centers at large financial institutions with "bonus-malus" reserve accounts, which penalise employees whose actions trade current profit for future losses. This would essentially bring "claw backs" into the compensation system. UBS's bonus scheme, granting bonuses in the form of claims on a portfolio of toxic assets, is a good example.

2. Prevent obvious regulatory arbitrage (privatising, for example, the financial investments of government-sponsored enterprises) and charge for guarantees – deposit insurance, too-big-to-fail loan guarantees and the bailout – using marking-to-market that reflects leverage and risk in a continual manner.

3. Recognise the negative externality of large, complex financial institutions (LCFIs). Then quantify the systemic risk of LCFIs and "tax" (through capital requirements or deposit insurance fees) their contributions to systemic risk rather than individual risk.

4. Enforce greater transparency of over-the-counter derivatives positions and off-balance-sheet transactions, employing centralised clearing for standardised products and, at a minimum, centralised registries for customised ones so that counterparty risk can be assessed.

As the authors write, the challenge would be to redesign "the regulatory overlay to make the global financial system more robust without crippling its ability to innovate and spur economic growth".

Update 1
Fed Chairman Ben Bernanke has called for tougher regulation of the financial markets to address systemic risk. At the same time, Mr. Bernanke stoked a new controversy by endorsing more flexible accounting rules that would not force banks to book as many losses during an economic downturn as current rules require, thereby virtually endorsing a policy known as "regulatory forbearance". Supporters argue that this is necessary to reduce the "pro-cyclical" aspects of current regulation — the tendency of accounting rules and capital requirements to aggravate both financial retrenchment during a slowdown and financial excesses during a boom.

Update 2
Alan Blinder on how skewed executive compensation packages led to distortions in incentives. He writes, "boards should abolish go-for-broke incentives and change compensation practices to align the interests of shareholders and employees better. For example, top executives could be paid mainly in restricted stock that vests at a later date, and traders could have their winnings deposited into an account from which subsequent losses would be deducted."

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