"Radical reform will be flawed by compromise and fudging"

John Plender in the Financial Times offers a hit list of what he views as the obvious priorities for financial services reform and assesses the odds of them being implemented. It’s a useful exercise, but also a sobering reminder of how difficult it is to effect change in an industry that has proven to be very effective in co-opting its minders.

From the Financial Times:

History tells us that the scope for regulatory reform is directly proportionate to the severity of the crisis. The rescue of Bear Stearns and the deepening impact of the credit implosion on the real economy make it clear that radical financial re-regulation now looms. The snag is that radical remedies may not gravitate towards the right problems.

Consider some obvious systemic flaws exposed by recent events. Clearly, the Basel capital adequacy regime needs greater emphasis on liquidity. It could also usefully address the problem of pro-cyclicality in banking whereby risk appetites increase as the cycle cranks up.

Then there is the extent to which new-fangled paper has deserted exchanges for more opaque over-the-counter markets, a phenomenon that left Bear Stearns too interconnected with important counterparties to be allowed to fail.

Also urgently needed is an overhaul of the incentive structures that encourage strategies that generate steady returns upfront at the cost of exposure to low-probability, but potentially catastrophic events. More crudely, bank bonuses need to be clawed back where profits turn to losses.

The degree of leverage in investment banking has been too high. It could readily be curbed. And in the retail market there needs to be greater due diligence in the origination of loans. The list could be extended at will.

But, how much of this short agenda will actually find a radical and coherent regulatory response?

The size of the liquidity shock has been such as to guarantee serious change in the Basel II framework on this score. No doubt capital requirements will become more stringent too. But when it comes to pro-cyclicality, Bill White of the Bank for International Settlements identified a fundamental difficulty in a lecture last month at the London School of Economics: what he dubbed “the will to act”.

The Basel regime is heavily influenced by big bank lobbying. It is worth recalling that when Peter Cooke, then of the Bank of England, was driving this regulatory process, efforts to give liquidity a bigger role were stymied by the banks. They argued that liquidity was hard to define and measure, and that comparisons across national boundaries would lead to regulatory arbitrage. It was easier to build a consensus around the adoption of capital as a key indicator of financial soundness in the consensual process of international co-operation.

So, in the land of the one-eyed banker, capital became king. The liquidity measures that might have mitigated the damage in the current crisis went begging.

With pro-cyclicality it may prove to be the same story. And it will be compounded by tax authorities who fear anything that looks like generous provisioning and by accountants who have their own agenda on this subject.

As for the opaque OTC markets, it would be relatively easy to force business back on to the exchanges, where counterparty risk is minimised. Institutions such as mutual funds could be prohibited from investing outside exchange traded, Securities and Exchange Commission- registered paper. Leaving aside the issue of whether this is desirable, it would certainly unleash a ferocious lobbying campaign from the banks because the OTC market is where the money is. With the US Treasury in the hands of Henry Paulson, late of Goldman Sachs, whose influence in Washington is second to none, the odds are surely stacked against.

Distorted incentives, meantime, take us back to the dilemma of Warren Buffett, the great investment sage, when he owned a chunk of Salomon Brothers. His attempt to install a rational bonus scheme came close to precipitating an immediate exodus of key talent. Buffett retreated. Hard to believe the regulators can succeed where he failed.

Where we will get radical change in a US election year is on due diligence in lending to the retail home owner and investor. The risk is that it will be clunky, bureaucratic and end up shrinking the volume of mortgage lending even more. So keep your expectations in check. changes to the institutional architecture and individual regulations will be subject to compromise and fudge. Radicalism will be flawed.

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  1. vlade

    “Distorted incentives, meantime, take us back to the dilemma of Warren Buffett, the great investment sage, when he owned a chunk of Salomon Brothers. His attempt to install a rational bonus scheme came close to precipitating an immediate exodus of key talent. Buffett retreated. Hard to believe the regulators can succeed where he failed.”

    Of course they can. If everyone has (to have) rational bonuses, there isn’t anywhere to run.

  2. Richard Kline

    Plender nails a key flaw in the present capital management regime late in his article: the bonus system. This is also where one can have the most impact on behavior. Here’s a simple proposal: Pay the putative talent bonuses for success, but also pay them for maintaining sound reserves, _and bill them for losses_.

    How much for each is a matter of fine-tuning and perhaps institutional culture. If every firm did it, the putative talent has nowhere to go, except to go private which they often do now anyway. Good riddance to greater fools. The major problem is that the gamblers have no skin in the game on the loss side of the ledger. Seriously, if the bonus club also signed in their contracts that they had to pay out _personally_ a set amount or point level for losses accrued from their deals, and others assessed the losses, we’d see sanity return. Right now, though, it’s a rigged game: heads I win, tails I win, and I read the coin . . . so pay me.

  3. a

    “Hard to believe the regulators can succeed where he failed.”

    1/ Let an IB go bust. That will concentrate minds wonderfully.

    2/ Continue to let hedge funds go bust. That will create surplus suppy.

    Anyway, the market will be correcting the excesses anyway. It’s very hard to make money without money, which is the state of the market at present (no liquidity), so there’s going to be some downward pressure on head counts and bonuses…

  4. Anonymous

    OT, but highly correlated:

    Rep. Henry Waxman, chairman of the House Oversight and Government Reform Committee, wrote a letter to New York Fed Governor Timothy Geithner to inquire about the selection of BlackRock Financial Management Inc. as the asset manager for the deal that allowed JPMorgan Chase & Co. to purchase Bear Stearns at bargain-basement price.

    When bank managers feared investment bank Bear Stearns’ collapse, the Fed put together the emergency deal to avoid a Wall Street-wide panic. Bear Stearns was hamstrung by heavy investments in shaky mortgage-backed securities.

    “Only limited details are known about the Federal Reserve’s understandings with BlackRock. It appears, however, that BlackRock is now directly responsible for managing a $30 billion portfolio on behalf of the American taxpayer,” Waxman wrote.

    Waxman said he wants to know how the Fed came to select BlackRock, which appears to have secured a long-term deal with the Fed without competition usually sought in a government bid. Waxman said he also wants to know more about what compensation BlackRock will receive in exchange for its work.

    Geithner’s “testimony before the Senate Banking Committee offered few specifics” about the deal, Waxman said.

    Detailing a half-dozen specific questions about the deal, Waxman asked for a response by April 18.

    Re: Now you see why Blackrock is managing Bear Level 2 unobservable assets @ Treasury/Fed:

    Merrill Lynch owns approximately half of BlackRock, one of the world’s largest publicly traded investment management companies, with more than $1 trillion in assets under management.

    Re: The Wall Streeters seem to assume that the next step will be the creation of something like the Resolution Trust Corporation….. Or, as David Rosenberg of Merrill Lynch told the firm’s clients last week, “ . . . the outright purchase (by government agencies) of illiquid mortgage-backed securities is probably required, and could employ government-backed fiscal action . . . The Federal Reserve itself could buy some of those securities, but the Fed alone cannot unclog the congestion in the capital markets, in our opinion.”

    Re: Former Federal Reserve Chairman Paul Volcker questioned the central bank’s decision to rescue Bear Stearns Cos. with a $29 billion loan, saying it was at “the very edge” of its legal authority.

    From Nakedcapitalism (TallIndian said…): The NY FED proclaims

    The portfolio consists of collateralized mortgage obligations (CMOs), the majority of which are obligations of government-sponsored entities (GSEs), such as the Federal Home Loan Mortgage Corporation (“Freddie Mac”), as well as asset-backed securities, adjustable-rate mortgages, commercial mortgage-backed securities, non-GSE CMOs, collateralized bond obligations, and various other loan obligations.

    All valued by BSC!

    And the NY FED actually states that even revealing the CUSIPS of these instruments poses a ‘danger to markets’!!!!!!

  5. Anonymous


    Chairman Waxman Requests Details of Federal Reserve’s No-Bid Arrangement with BlackRock

    Chairman Waxman requests details of a potentially long-term arrangement between the Federal Reserve and BlackRock, an investment advisory firm selected to manage $30 billion in assets backed by federal taxpayers.

  6. VennData

    All the plans fail to address the real problem of regulating; the apologists say we can’t do too much regulating of firms that are “too big to fail.”

    So – as our esteemed VP declared recently – split them up. A system (think Internet, the electricity grid) that are not dependent on any node are more robust.

    Imagine the small town banker demanding a $150M Golden parachute. Or the local investment advisor with a 386 machine buying all the stocks in the index having a trillion dollars in counter party risk.

    Now that we’re de-leveraging, let’s de-size.

  7. Tom Ricciardi

    The OTC opaqueness and lack of transparency that permits all this “plundering”, until the roof starts to leak, is a throw back to former times. When the Equity OTC market was a “thing” called the Pink Sheets, which was the listing of all “Market Makers” and their last bid/asked on securities for which they were “making a market” or more euphemistically, “plundering” the market. This plunder, through exhorbitant spreads, went on until Nasdaq offered level 2 prices to day traders. Then they started picking off stocks and coming into the middle of the fat spreads, and eventually drove the fat cat market makers out of business.

    The OTC derivative collateral market needs to be electronically structured, so that at least the collateral starts to get “priced” and published. If all the collateral for every piece of a complex derivative had to be valued as a “currency”, then that would add a lot of transparency to the market and start to let the “little people” play, or at least start to understand. Of course, it would cut down on the big time profits at the Global Investment Banks and their obscene bonuses, but it would start to keep the “market makers” from “hiding” the ball and it would level the playing field a little bit.

    Make it mandatory to price the collateral and treat the collateral as the currency. Publish the prices/ticks and volume on the collateral, and then it gets down to a more rational risk management task instead of trying to “know your counterparty” from the bar or the golf course. price the collateral, publish the prices and volume and then we will see.

    So, the idea behind viewing the collateral as the currency, is to be able to track that currency as it moves up or down the food chain of the derivative structures. If a piece/type/size of collateral starts to rise in price, then the derivative strcuture is getting more complex. So it gets a little more simplified to track and measuring risk, and we know more about what’s going on.

    On Blackrock, would someone please buy Henry Waxman a cigar. Of course, the Fed would “select” Blackrock, a very mysterious and dark fund manager, formerly owned by PNC bank prior to Merrill. One could wonder why the majority of their ETFs started to dramtically tank at the time that the Sub Prime problem started to become visible to the “inside market makers”. Do you think that Blackrock was given an opportunity to protect its and its other counterparties rear ends and potential industry events, by having “exclusive” privilege to unraveling or “covering up” the OTC derivative mess?

  8. Anonymous

    Reform..? No, we get nepotism, collusion and corruption, alondside discretionary abuse and theft!

    Re: Greenspan the whore working at a hedge fund:

    The best way to describe Peter Fisher is that he’s one of those behind-the-scenes guys who keep Wall Street from coming apart at the seams–which it almost does every few years. As the recently departed undersecretary for domestic finance at the Treasury, believe you me, Peter Fisher is known to every fiscal power broker from D.C. to Delhi. He’s an unusual guy. For one, he gets visibly excited talking about financial policy. And for another, he’s been pretty good at implementing it. He’s also obsessed with the business of risk.

    Now Fisher has hung up his government scepter to join bond house BlackRock. (Fisher was on everyone’s short list to head the New York Fed or lead the New York Stock Exchange.) It’s a cashing-in of chips, partly.

    These people have no integrity

  9. Anonymous

    Wait a minute, Citigroup didn’t want to act rationally? Shocking!

    The fact that Citi rejected a proposal by Buffett is a sign that he’s right and Citi is wrong once again.. not that Salomon is correct!

  10. zak822

    Richard Kline, in his last paragraph, defined the cause of the problem perfectly. Few others have even touched on it, but unless this part is understand and talked about openly we’re just going to have to do all this again. And Kline even offered a solution.

    “The major problem is that the gamblers have no skin in the game on the loss side of the ledger. Seriously, if the bonus club also signed in their contracts that they had to pay out _personally_ a set amount or point level for losses accrued from their deals, and others assessed the losses, we’d see sanity return. Right now, though, it’s a rigged game: heads I win, tails I win, and I read the coin . . . so pay me.”

    Kudos, Richard!

  11. S

    People have been talking to about the inequity of the bonus system for decades (inside and outside the banks). The problem is free agency (Wolf’s call to regulate it a month or so ago in opinion piece). The comment on assinging a loss provision is cetainly an approach but with so many savvy lawyers (Yves post on the BEar deal) I assume various venting mechanism would be in place making such recover challenging at best. Plus as more firms move to performance based on firm outcome (%) how do you allocate loss to one person/cost center? Perhaps the greater problem is a psychological one: Wall Streeters need to be reedcuated on the amount of value they add. There isn’t a banker out there worth more than X a year. They are renting capital at best and are certainly entitled to an adequate return – utility. Free market remian intact as the gifted bankers with a nack for creating value will flee to hedge funds where they can risk private capital. Capping pay will never fly it is unamerican. That leaves the logical flank fee structure

    In the long term this would be an incredibly healthy thing for resource distribution in the United States as it is forced to pursue a soft reindustrialization. then again maybe we can trade away some bankers for real engineers.

  12. Richard Kline

    To S, and more on financial fair practice:

    I say putative financial talent because, as you, I see a limit to the actual worth of many of the boss speculators. Insofar as I can tell, they usually make major money by finding a small situational advantage no one else is onto yet, by using massive leverage, or both. Once the rest of the industry follows on behind, their ‘strategy’—really just time-dependent corners—is constrained, and they do no better than anyone else. Yes, those few good years are worth something, but not what the ibanks are paying for it. Trader profiteering is the result of institutional and industry culture around which mythology of ‘talent’ accrues more than due to special _sustainable_ wizardry.

    Re: Recovery for dealing losses being difficult, sure it would be: so don’t recover, escrow. Part of each year’s bonus is escrowed against future losses rather than paid out, building up a ‘recoverable asset’ to the firm in the event of losses or unsanctioned or illegal activity. The escrow belongs to the employee like pension money, and they cash out when they leave _and_ when their positions have cleared. Oh sure, cap the total pay-in at some reasonable if high level, some especially lucky traders or fortunate units will max out. And don’t limit the recoverable penalty to what’s in the escrow necessarily; that’s just the earnest money. But down the road the employee collects the escrow if they finish in good standing; fair is fair. One needn’t necessarily put a cap on compensation; the tax system should take care of _that isssue_, frankly. The whole idea of loss recovery is to limit firm exposure to excessive risk, not meet compensation head on per se.

    The idea of unit- or firm-wide bonuses for returns is . . . loopy to me, but the same applies. If you have standing to collect bonus money, you see a slice going into escrow, and are evaluated against reserves and losses per your bonus (but not per your salary). Will bright guys sans scruples find ways to end around, as with the whole stock option greedfest? Of course, innovation is the American way; let’s start with a clear solution to a known ill and burn other bridges when we come to them.

    No single firm could implement such unilateral policy; employee flight is a real issue. Well, the industry is down right now, right? They need public dough, and they need counterparty confidence. In another post of this date, William Kidder is cited for the points of his ‘Good Citizen’ proposal, a set of self-imposed industry standards. Explicitly as one of them should be a ‘bonus management’ clause of just this nature: we don’t ask the industry to initiate this firm by firm, or start by passing legislation. Rather call this clause and others similar to Kidder’s good points an industry Fair Practice guideline. One needn’t even call this a ‘comensation clause;’ call it a ‘shared risk’ clause. All financial concerns which qualify for Federal Reserve repos are required to be binding signatories to such a set of guidelines. Ultimately, it would be better if this was a regulatory requirement if not necessarily a statutory one; it might start as a voluntary one. But make it necessary: the piglets shouldn’t get an IV to make it through bad times without being required to give up something and behave better. Now, they need us, so make them _ALL_ sign on to keep rolling over these repos—and they’ll do it: they have no choice. And frankly, they may well end up better managed for it, we’re saving them from themselves.

    Putative ‘talent’ may still leave to set up their own boiler room outfits in office parks, yes. However, one might require public entities to only do business with firms who have binding commitments to the Fair Practice guidelines, whether those firms were repo elibible or not. Such a requirement would cut off non-signatories from major pools of capital. And it would identify non-signatories to all and sundry as Un-Fair Practitioners: that’s called fair warning.

    Re: soft reindustrialization, I’m all for it, and we have needed to go this root for thirty years. We got Republican imperialism, bigot channel noise machines, and speculative manias too much instead. Now, we desperately need to re-expand our actual productive base. Can we? Yes. Will we? Well, we sure as Hell won’t try as long as we can play roulette with other peoples money on a mass scale: who’d work when they can (supposedly) just buy a ticket on the gravy train and watch that ticket appreciate in price? The US is hardly through; we just need to take a hard look in the mirror and capitalize on our _real_ talents. And we won’t find any too damn many of them with their feet up in a corner office above it all.

  13. Frank Ruscica

    The diagnosis is not at issue: moral hazard risks abound.

    The cure, then, will maximize the likelihood that gratuitous moral hazard is too impolitic.

    Historically, a job largely for the fourth estate (e.g., Jacob Riis, H.L. Mencken).

    How, then, to make it maximally profitable for the fourth estate of today to muckrake?

    Imho, the key insights:

    1) The introduction of particular online markets, starting with a new kind of market for the ad spaces on blogs, will provide people with new and improved ways to develop, showcase and profit from expertise.

    2) Owning popular markets of the aforesaid kinds is an ideal way to increase profits for an American media conglomerate that owns a broadcast TV network.

    3) The less benefit individual speculators can derive from moral hazard, the more they will utilize said markets.

    Details are online at http://www.loveatmadisonandwall.com.

    Given the above, the sooner media conglomerates start introducing/popularizing the aforesaid markets, the sooner a lot of top-quality entertainment programming will, in part:

    1) increase awareness of (proposed) public policies that (would) put taxpayers on the receiving end of gratuitous moral hazard (e.g., increase awareness via a next-gen Jed Bartlet channeling Jon Stewart and Vietnam-era Walter Cronkite)
    2) showcase elected representatives who protect taxpayers from gratuitous moral hazard



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