I get worried when the Financial Times’ Martin Wolf starts adopting Stephen Covey-esque sloganeering, particularly when he goes so far as to call his financial services reform proposal “the seven Cs.” Eeek.
Earth to UK: one of the big hidden advantages you have is that the lingua franca is your language. That cloying business jargon so popular in America that we have managed to export is not an innovation, it is a debasement. Anyone who can speak and write in an unvarnished manner can trounce those who traffic in gobbledegook.
To be frank, this isn’t one of Wolf’s best columns, but that may be in large measure due to the near impossibility of setting forth how to fix the global financial system in his word budget. And I have omitted the liveliest part, namely, the set-up, in which he review Paul Volcker’s recent speech at the Economic Club of New York, simply because it has been covered elsewhere.
Nevertheless, US readers are likely to find his recommendations to be thin gruel, but remember, there’s a valid reason. The UK is a principles based system, so general, high level statements are more meaningful in that system than in ours, where sadly, the devil is in the details. But even giving that allowance, Wolf at points ducks questions he could have addressed. For instance, he mentions the problem of rating agencies, yet fails to mention any solutions. Several are on offer; surely Wolf could have given a thumbs up to one he likes.
Similarly, he sees the main problem in the “originate-to-distribute” model as bad incentives which can be solved by having the originators hold some of the riskiest tranches. Um, don’t underestimate their ability to jigger the structures so as to still leave other parties holding the bag. The real problem with the originate to distribute model may be that it is seeking to create a free lunch by reducing the equity that needs to be held against loans. What if that in the end is a false economy? My sources with good regulator contacts tell me they expect to see a good deal more old-fashioned, on-balance-sheet intermediation. Mind you, that it not a view that is convenient for them to have; it implies that banks need to raise not only enough capital to cover their recent losses, but even more to allow for bigger balance sheets. Their view may be pragmatic, in that they see the market for securitized assets as sufficiently burned that it will not come back to its former size for quite some time. That degree of investor repudiation in turn suggests greater changes may be required.
Nevertheless, the advantage of a simple catchy list is that it provides a useful frame of reference.
From the Financial Times:
So here are seven principles of regulation. I call them the seven “Cs”.
First, coverage. Perhaps the most obvious lesson is the dangers of regulatory arbitrage: if the rules required certain capital requirements, institutions shifted activities into off-balance-sheet vehicles; if rules operated restrictively in one jurisdiction, activities were shifted elsewhere; and if certain institutions were more tightly regulated, then activities shifted to others. Regulatory coverage must be complete. All leveraged institutions above a certain size must be inside the net.
Second, cushions. Equity capital is the most important cushion in the financial system. Also helpful is subordinated debt. If Bear Stearns had had larger equity capital, the authorities might not have needed to rescue it. Capital requirements must be the same across the entire financial system, against any given class of risks. But there must also be greater attention to the adequacy of that other cushion: liquidity.
Third, commitment. The originate-and-distribute model has, it is now clear, a huge drawback: originators do not care sufficiently about the quality of loans they plan to offload on to others. They do not, in Warren Buffett’s phrase, have “skin in the game”. That makes for sloppy, if not irresponsible or even fraudulent lending. Originators should be required, therefore, to hold equity portions of securitised loans.
Fourth, cyclicality. Existing rules are pro-cyclical. Capital evaporates in bad times, as a result of write-offs, thereby forcing contraction of lending, worsening the economic slowdown and further impairing assets. Mark-to-market accounting, though inherently desirable, has a similar effect. One solution could be to differentiate between target levels of capital and a lower minimum level. Institutions that have minimum capital in bad times would only be required to aim for the higher target level over an extended period.
Fifth, clarity. Lack of information, asymmetric information and uncertainty are inherent in financial activities. These are why they are vulnerable to swings in collective mood. The transactions-orientated financial system is particularly vulnerable, because information has to flow freely across arms-length markets. So a big challenge is to generate as much clarity as is possible. One issue is the calamitous recent role of the rating agencies and the conflicts of interest under which they operate.
Sixth, complexity. Excessive complexity is a significant source of lack of clarity. It is particularly damaging, as we have seen, to the originate-and-distribute model, because markets in complex securitised products may, at times, seize up, forcing central banks to become “market makers of last resort”, with all the difficulties this entails. One possibility then is to insist that all derivatives be traded on exchanges.
Seventh, compensation. On this I can do no better than quote Mr Volcker: “In the name of properly aligning incentives, there are enormous rewards for successful trades and for loan originators. The mantra of aligning incentives seems to be lost in the failure to impose symmetrical losses – or frequently any loss at all – when failures ensue.” Whether regulators can do anything effective is unclear. That this is a challenge is not.
John Maynard Keynes wrote of an eighth “c”. He argued that “when the capital development of a country becomes a byproduct of the activities of a casino, the job is likely to be ill done”. He had a point. Features of a casino will always be present in a financial system that performs the essential functions of guarding people’s savings and allocating them where they can do most good.
Regulation will always be highly imperfect. But an effort must still be made to improve it.