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“Sept 08” will reverberate down the economic history books for a generation – or will it be for two generations? In the
Shrill calls for “more regulation - and quickly” in an already heavily-regulated business may be missing a much deeper malaise. There may also be much broader geo-political implications that follow on: in financial markets, the term “Made in the
However the good news is that US electors sent their politicians a clear message of moral outrage and indignation that seems entirely appropriate. But great wisdom is required to ensure that the moral message is directed into changes that will retain the best of the modern financial system yet rid society of the worst excesses. There needs to be sufficient time to reflect on how this can be done effectively, and that must not be driven solely by the chance timing of elections in both the EU and US.
The simple fact is that there has also been a massive regulatory failure to allow all this to happen. Public assurances of solvency were being issued right up to the eve of collapse. A bigger dose of the failed medicine is unlikely to cure the disease, though it may give temporary alleviation. It could even compound the problem eventually: Fanny and Freddie were shareholder-owned, profit-seeking, exchange-listed but “Government Sponsored Entities” that the
The deeper social problem is one that is not susceptible to a quick fix. The aging of society – quite properly - has led to the understanding that citizens must save to fund their own retirement. But the logical consequence is a build-up of financial assets in pursuit of the highest possible returns – almost irrespective of any risks because the state can be relied on to provide bail-outs. The generation raised with this deep belief can hardly imagine that personal precautionary thoughts are necessary.
So they require their mutual fund manager or life insurance provider to maximise investment returns in the short run. That pushes pressures down the line to the corporate sector to perform at all costs, and as quickly as possible. Correspondingly, that other set of major financial investors – pension funds of large corporations – must also perform. So most sets of shareholders provide massive incentives for rapid profit growth – and quickly sanction any perceived failures.
What can be done about these problems? In the short run, probably very little can be done to resolve “societal” ones! So it is even more important that the system of incentives within the financial system is calibrated to reward thoughtful innovation that can deliver real benefits to society over a reasonable period of time. That is the essence of capitalism – a system that has delivered huge improvements in society’s living standards. Many proposals are on the table – or nearly so – to fix identified technical shortcomings within the regulatory framework. But a variety of reports have already emerged that lay much blame on management failures.
So a few early-stage personal thoughts are set out below:
1) If the management is unaware of the true nature of the risks being run by an institution, then the chances of a regulator finding out are slim. So the small number of executives who are the real “controllers” of an organisation must be held jointly and severally accountable for what their colleagues do – in effect re-create the old concept of unlimited personal liability within a partnership. That personal liability for actions taken should continue long after formally leaving the partnership until the consequences of the actions are clear – for better or worse.
2) There is much discussion about the “originate to distribute” concept but that has provided many benefits in the past. Perhaps the classic is the German Pfandbriefe system where all the credit risk remains with the lending institution and the securities they issue are legally tailored to give absolute matching of cash flows into the special vehicle, and out again to investors. This approach ensured that the bondholders did not lose money throughout the turmoil of 20th century
3) Instead of this careful cash-matching structure, it now seems possible that Credit Rating Agencies (CRAs) will be pushed to take on the public authorities’ role of regulator for example, in confirming the robustness of all information that is used.
4) Then there is the role of accounting. The fact that apparently-solvent banks have failed underlines the need for investors/depositors to be fully appraised of the current value of a bank’s assets. But it should not lead to a fruitless search for a market price when the awkward fact is that, in the middle of a crisis, there is simply no price at which willing buyers will engage with the seller. No accounting standard can create such a price – except a fictional one.
5) So we also need to improve the chances of there being an active market in a particular security. Disturbingly, about three-quarters of all derivative contracts are Over-The- Counter (OTC) rather than regularly traded on an exchange. Only now are we even getting the basic settlement of OTC trades thoroughly worked out. But merely being able to settle a transaction efficiently does not guarantee the existence of a price that can be used to value an institution’s assets. There may have to be significant incentives for firms to hold visibly-traded assets – and corresponding dis-incentives to hold opaque and untradeable ones.