25 September 2008

FASB Herz - regulatory architecture needs to be re-thought

Balkanized regulatory systems, both in the US and across international financial markets, may have made it difficult, if not impossible, to rein in the exuberance driving the markets, the FASB chairman said.

“Over many decades we have built a highly fragmented, balkanized regulatory structure over our financial services and capital markets”, FASB chairman Herz said. “And there are black holes of little or no regulation”, he added pointing to the US regulatory structure of banking and insurance regulation.

 

“Balkanized regulatory systems, both in the US and across international financial markets, may have made it difficult, if not impossible, to rein in the exuberance driving the markets”, he said adding that regulators failed to fully understand the risks their regulatees were taking on.

 

In a relatively short period of time there was a rapid and explosive growth of unregulated, opaque markets that lacked a proper infrastructure, such as the transparent pricing and clearing mechanisms, he explained.

 

“To some observers, it was a “Wild West” version of financial markets in which the unchecked growth of products such as credit default swaps could suddenly swell to over $60 trillion in notional value, prompting the question: ‘Where were the regulators?’,” said Herz.

Herz draw an a series of lessens to be learned from the crises. Sound markets require a proper infrastructure, he said, and fundamental changes may be needed in our capital markets and financial services industry. He also addressed the misleading and damaging payment incentives of managers. “Perverse incentives lead to perverse outcomes”, he said.

 

Touching upon fair value accounting, Herz underlined that implementing fair value in illiquid markets can be challenging and difficult. “There are important questions to be asked”, he said. “Does it lead, reflect, or lag reality? Are there genuine concerns over procyclicality ? These are important questions and issues; but I would ask, what is the alternative?”

 

“The harsh reality is that we can’t just suspend or modify the financial reporting when there is bad news”, he said.

 

Full speech

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