Tuesday, 2 February 2010

A Failure of Regulation

A Failure of Regulation.
How to reform Regulation to avoid a relapse.

Chapter 1 – A Failure of regulation

Much has been said and written on the causes of the financial crisis of 2007/2009.


Fingers have been pointed at the lax monetary policy operated by the Fed following the recovery from the bursting of the tech bubble. Others have made a connection with the liquidity created by the structural payments imbalances which forced surplus countries to dump their excess savings on the US credit markets, forcing long term rates to lose their linkages with the Fed’s traditional control over short term interest rates.

Who can forget the amazement of Alan Greenspan at seeing the Fed’s loss of influence over the long term end of the interest rate curve, which amazement Greenspan had described as ‘conundrum’?

Some have blamed the crisis on the inability of banks to self regulate and their indulging in excessive leverage to reap increased profits, leading to outrageous executive bonuses.

Some have blamed the lax control on the initiation of sub-prime mortgages and on the distribution model for mortgage backed securities by major banks who had no contact whatsoever with the mortgage borrowers underlying their CDO’s; such that banks were totally blinded by their defective mathematical models on the true credit worthiness (or lack of it) of the borrowers underpinning their exposure to sub-prime mortgages.

Why not blame the Rating Agencies who at the very least have to carry responsibility for stamping high ratings too liberally on the Alt A super senior tranches of the CDO’s, performing the financial equivalent of the miracle of Cana, transforming water ( probably dishwater) into fine wine?

Should we exculpate the gullible mortgage borrowers who allowed themselves to be duped into believing they can afford mortgages clearly beyond their ability to service, purely on the utopian expectation that such mortgages can be continually refinanced as their property undergoes an eternal increase in market price?

A few have also blamed the US Treasury for mishandling the problems of Lehman Brothers which was the triggering event for the financial meltdown and the near complete seizure of the credit markets in the last quarter of 2008 and the first quarter of 2009. They argue, in my view rightly, that allowing Lehman to file for bankruptcy made a dangerous situation tragic, and the extremes could have been avoided if Lehman were nationalised and subjected to an orderly wind down.

These, and others, are all valid contributory causes to the financial turmoil experienced in 2008/2009. What is however underpinning most of these causes is a failure of regulation.

If regulation were effective banks would not have been allowed to over-leverage and take extreme risks jeopardising their own existence. If regulation were effective banks would not have turned their investment banking divisions into hedge funds financed by ordinary deposits. If regulation were effective banks would not have been allowed to warehouse enormous quantities of Alt A high rated sub-prime CDO’s on their own balance sheet and would not have been allowed to take substantial risks off balance sheet through SIV’s and such like investment vehicles. If regulation were effective Banks would have had a much more comfortable cushion of own capital to face the downturn and financial crisis without the resulting loss of confidence.

So this financial crisis has been a failure of regulation. This is not to say that Bank Regulation, if properly dosed and rigorously applied, could have saved the economy from the entire crisis. But even if a crisis would have occurred it would have been an asset price crisis and not a credit crisis. It would have hurt investors who invested their own money in over-priced assets but would not have affected the strength of the banking system through clogging of the credit mechanism and erosion of banks’ capital through market value losses on their assets.

With proper regulation the 2007/2009 crisis could have been an asset price property bubble like the technology bubble of the year 2000 where the banking system remained strong and capable of keeping the plumbing of the credit markets operating efficiently to help pull the economy out of a mild recession or even prevent such recession altogether.

So yes this financial crisis was mostly a failure of bank regulation!

And if proof were needed that this was so, one need look no further than the testimony given by the ‘eminence gris’ of light touch regulation and self regulation, the longest serving Chairman of The Federal Reserve, Alan Greenspan.

On the morning of October 23, 2008, Greenspan, who had retired from the Fed for some 33 months earlier, was back on Capitol Hill to give evidence before the House Committee on Oversight and Government Reform, that was enquiring into what led to the sub-prime crisis.

Chairman of the Committee, Democratic Congressman Henry Waxman, asked:

“Dr Greenspan, you were the longest serving Chairman of the Federal Reserve in history and during this period of time you were, perhaps, the leading proponent of deregulation of our financial markets.... You have been a staunch advocate for letting markets regulate themselves. Let me give you a few of your past statements :

“There’s is nothing involved in federal regulation which makes it superior to market regulation”

“There appears to be no need for government regulation of off-exchange derivative transactions”

“We do not believe a public policy case exists to justify government intervention”

My question for you is simple. Were you wrong?”

Greenspan replied:

“Partially. I made a mistake in presuming that the self-interest of organizations were such that they were best capable of protecting their own shareholders and their equity in the firms. ..... The problem here is something which looked to be very solid edifice, and, indeed, a critical pillar to market competition and free markets, did break down. And I think that, as I said, shocked me. I still do not fully understand why it happened and obviously, to the extent that I figure out what happened and why, I will change my views.”

Greenspan, an acolyte of the great libertarian philosopher and believer in free markets, Ayn Rand, admits in Congress that he made a mistake! News rarely comes in crisper formats.

He continued:

“ To exist you need an ideology. The question is whether it is accurate or not. What I am saying to you is yes, I found a flaw. I don’t know how significant or permanent it is, but I have been pretty distressed by the fact..... I found a flaw in the model that I perceived as the critical functioning structure that defines how the world works, so to speak.”

Waxman retorted:

“You found a flaw? In other words, you found that your view of the world, your ideology, was not right. It was not working.”

Greenspan replied:

”Precisely! That’s precisely the reason I was shocked. Because I had been going for forty years, or more, with very considerable evidence that it was working exceptionally well.”

A greater admission than that is almost impossible. The person who had persuaded Congress that it was not necessary to regulate financial derivatives and that the evolution of financial derivatives without any regulatory strings attached was a blessing, as risk was spread thinly across a wide spectrum of investors, ensuring that when the shock came no single institution would be brought down, could not preview that the opacity of the system he allowed would on the contrary threaten to bring down the whole system.

So let me repeat in block capitals:


Chapter 2 – Self regulation model was bound to fail

So Greenspan admits he made a mistake in presuming that the self-interest of organizations were such that they were best capable of protecting their own shareholders and their equity in the firms.

But how could any rational person make such mistake? Anybody with an average level of intelligence can understand that in the game theory the prisoners will never go for the optimum solution which would clearly result from their rational collaboration if they were dealing with each other through open communications. The market is much more complicated than the prisoners’ dilemma. Rather than just two players there are hundreds of players each trying to outperform peers.

It would be utopian to expect banks to behave collectively in a rational manner by uniformly avoiding undue exposures to protect from systemic risk, as if banks had perfect knowledge of each others’ strategies and a clear vision of the consequences resulting from departure from such perfect collaboration.

Reality is different. Banks operate in strong competition with each other and the markets judge banks’ management by their quarterly results. If one bank departs from perfect collective rationality and starts operating more aggressively, taking on more leverage to achieve better short term results, it will not be long before many of the other operators will be forced by market expectations to adjust their strategies to compete as aggressively. Before you know it risk has notched up a few steps across the whole financial markets.

Greenspan argument must have assumed that since banks’ management are themselves substantial shareholders in the organisation they lead, mostly as a result of having part of their remuneration packages paid in blocked shares or share options, they would, in self-interest, steer clear from taking short term risks that could prejudice the value of their long term investment in the equity of their own firms.

Reality has proven otherwise. The CEO’s of Bear Stearns and Lehman Brothers at the time of their failure ( or in case of Bear Stearns near failure before it was saved by JP Morgan Chase in a Fed/Treasury assisted takeover) had most of their personal wealth locked up in equity holdings of the organisation they were leading.

But it is clear that beyond a certain level of wealth, the motivation comes more from the honour and satisfaction of winning ( or perception thereof) in the markets, rather than in cautious capital preservation.

Especially when banks reach a certain level of size which helps to solidify the perception of being too big to fail, bank managements consider themselves protected enough on the downside to take further risks to extend the upside.

Only proper and effective regulation could force banks to avoid leverage and exposure which could present risks to the whole system. In the absence of a situation where banks are broken down into extremely small pieces, resulting no doubt in substantial and very undesirable lack of efficiency in serving clients as they need to be served in a global economy, regulation has to be pro-active enough to bring into line, in a very timely manner, any bank that breaks away from the long term collaborative maximum return option of the prisoners’ dilemma, in order to secure for itself short term advantage over its competitors.

This is the antithesis of the self-regulation so adored in the Greenspan era. It is regulation which has to be dynamic and effective in the old traditional way where a Regulator’s nod, wink or raised brows would be more important than the written rule.

This is particularly relevant in the area of risk management. History shows that financial strategies that start as a risk management tool, end up being themselves an instrument for leveraging risks. This is exactly the history of how Credit Default Swaps (CDS) came into being. They were ‘invented’ by the JP Morgan gang in order to reduce balance sheet credit risks of the Bank versus major corporations. They finished up being copied and imitated by the whole market that extended the concept to sub-prime mortgage area where statistical evidence of past performance was much more thin than in case of corporate defaults over the economic cycle. It is no coincidence that J P Morgan was one of the banks least hit by the sub-prime crisis. As ‘inventors’ of the CDS they had better appreciation than competitors of the inadequacy of their ‘invention’ in the mortgage field, especially as there was no historical data related to property values in the context of a nation-wide property crash.

In the next Chapter I will discuss what sort of regulation model is the most effective. Given now that there is a wide consensus on the need of effective Regulation and on the ineffectiveness of the self-regulation model, the next challenge is the promulgation of a globally accepted and harmonised Bank Regulation model which discourages or allows no space for regulatory arbitrage and which is dynamic and effective to ensure that we do not face a recurrence of the financial crisis, at least in our lifetime.

But before leaving this Chapter, I would touch on the reconfirmation of Ben Bernanke as the most important guardian of the international financial system in his capacity as Chairman of the Federal Reserve Bank in the US.

Bernanke’s reconfirmation process was hard work. Given that he was appointed by a Republican President and was being put up for re-confirmation by a Democrat President, one would have been forgiven for thinking that his re-confirmation would have sailed plainly through the US Congress. It was not so. In the end the 30% negative vote was the highest a Federal Reserve Chairman nominee ever got and even some of those who in the end voted for Bernanke’s re-appointment were quite critical in the appointment hearings. In the words of one Republican Senator who voted for Bernanke’s re-appointment in spite of critical posture during the hearings, he justified voting for Bernanke on the fear that in case of failure, the President would nominate someone worse. The sort of better the devil you know approach.

The reason for this ambivalence versus Bernanke’s suitability for the job is not difficult to understand. As a fire-fighter once the financial crisis started, Bernanke performed admirably. With a deep knowledge of how the crisis of 1929 led to the Great Depression of the thirties and fully understanding the policy errors made by the Federal Reserve at the time which only compounded the risks of depression, Bernanke was probably the best man to have in the position of Chairman of the Federal Reserve during the crisis.

He was a financial fire-fighter par excellence and performed admirably, often going to the extreme edges of the legal limits of his authority to save the system from imploding whilst the legislators were totally out of their depth in understanding the seriousness of the crisis, let alone in providing timely legal solutions for it.

As a fire-preventer however Bernanke ‘s guilt for not preventing or previewing the crisis could not be much less than that of Alan Greenspan. He was a member of the Board of the Federal Reserve for most of the noughties prior to his appointment as its Chairman In January 2006. And for the short period he was not on the Federal Reserve Board he was the Chairman of President G W Bush’s team of economic advisors with close linkages to the Treasury and the Fed.

There is no evidence that Bernanke ever showed serious dissent with Greenspan’s decisions, especially with his credo in the self-regulation model and on the excessively lax monetary policy following the bursting of the tech bubble.

History shows that Bernanke is a very efficient fire-fighter but if the crisis is behind us who wants a fire-fighting expert to rebuild a shaken edifice? What was needed was someone with a track record of capability to organise both effective legal bank regulation manuals and,perhaps more importantly, someone who can use the moral suasion authority of his position to budge the regulated entities to stay on the straight and narrow.

If such person does not exist, given that we have not experienced a similar financial crisis since the thirties, than my hope is that the experience of 2007/2009 has been a learning experience for Bernanke so that for the future he can be not only an effective fire-fighter, but perhaps more importantly, an effective fire-preventer.

Chapter 3 – An effective Bank Regulation model

Unless we want to roll back globalisation generally, effective bank regulation has to be globally co-ordinated.

The confusion resulting in the Copenhagen Summit on Global Warming held in December 2009 gives a taste of the near impossibility of reaching agreement on globally harmonised effective bank regulation which encompasses not only deposit taking banks, but the whole shadow banking structure.

The world seems caught in a living contradiction which unless resolved will lead from one financial crisis to another. Without global harmonisation, bank regulation would be ineffective. But global agreement on bank regulation is almost unachievable given the varying circumstances in the different jurisdictions. Just as an example: how can Canada be persuaded to breakdown or limit the activities of its major banks when it has had no confidence crisis in its banking sector?

It is quite evident that globalised harmonisation of bank regulation is unlikely to be reached if these regulations are modelled in quantities terms and are based on the experience of jurisdictions whose banking systems went in distress during the financial crisis.

It is more likely that global agreement can be reached if the harmonisation of banking regulation is defined in qualitative terms and in terms of general principles which are universally applicable and could be readily adopted by most if not all major jurisdictions.

A possible suite of such generally defined and qualitative regulation for universal application could include the following:

· All deposit taking banks, non-deposit taking banks ( non-banks that fund their operations through the capital or wholesale money markets), financial organisations who fund themselves on the capital or wholesale money markets for the purpose of performing bank-like operations (including hedge funds and private equity funds that undertake leverage) have to be responsible to a single regulator defined in their home jurisdiction who is to remain responsible for the global operations of the licensed institution.

· All exposures of the licensed institution are to be reported on balance sheet and off-balance sheet exposures are to be prohibited. Contingent exposures are to be reported upon as if they were real exposures and are to be calculated as real liabilities for liquidity and capital adequacy purposes.

· Licensed institutions have to keep a liquidity reserve equivalent to gross deposit withdrawals and market funding redemptions for an average of ___ days as experienced in the previous full financial year.

· Licensed Institutions are to have net tangible pure capital which bears a reasonable relationship to the size of its balance sheet and the risks posed by mismatches of maturities between its assets and liabilities. The size of such reasonable relationship is to be set by home country regulators in consultation with the regulators of host countries where the bank is operating, if such is the case.

· Capital which is subject to regular fixed coupon payment will only qualify as net tangible pure capital up to 50% of its gross value and only if it has no fixed date for redemption or if it has provision for conversion into share capital if circumstances so demand.

The question remains as to how is it possible to have such a loosely worded set of objectives turned into effective globally harmonised system of bank regulation.

I do not consider the lose wording and the generic nature of the established principles as a disadvantage for reaching the final objective. On the contrary I am very sceptic of too specific numerically defined regulation and this for two reasons.

Firstly because gaining general acceptance for such detailed regulation is a very laborious long term project which by the time it is brought to finality, even in the unlikely event that it has not been watered down through compromises to gain wide acceptance, it is generally poised to solve yesterday’s problems rather than tomorrow’s challenges.

Secondly because the financial industry is dynamic and any system of regulation defined in too much detail cannot keep pace with the evolution and innovation of the financial markets, especially given that in the past market operators have shown great ingenuity to re-model their operations to work around detailed regulation and still stay within the legal limits though not necessarily the spirit of the regulations.

 It would be indeed a pity if after God only knows how long and laborious the exercise for reaching consensus on globally well defined and numerically controlled regulation, this would be rendered ineffective by the spirit of innovation of the financial industry to circumvent such regulation.

For regulation to be as dynamic as the industry it is seeking to regulate there must be a totally new approach to it. The dynamics of regulation have to be re-jigged so that the spirit of innovation is channelled to work in favour of strengthening of the regulation and not against it.

For this purpose Regulators of the various jurisdictions have to agree on what I consider a simple method to give practical effect for the generally agreed principles to be translated into effective regulation which prevents banking crisis rather than cures it.

A leaf should be taken from the practice in most successful commercial organisations when it comes to Human Resource Management. Every year the organisation has to look at its human resources and after defining which elements are the weakest, (social considerations apart), will take steps to replace its weakest members by the input of new blood. Failure to do so, and human nature being what it is, will inevitably result that over time all human resources tend to lower their performance and the weakest performance will tend to pull down to its level the general performance of the whole organisation.

On the contrary knowledge that the organisation operates a dynamic HR policy that each year cuts out its weakest links will change the dynamics and stimulate the whole corpse to perform better in order to distance themselves from the possibility of their being the weakest link whose head would be next to go on the block.

This Q syndrome could be effectively applied by Bank Regulators for the organisations that fall under their regulatory jurisdiction. Every year each Regulator must look at the strength of the various licensed institutions and rank them in a queue of performance on the basis of the qualitative objectives agreed in the global system of general regulation.

Once the lowest ranking institution is identified, it will be given a few months to correct its weakness or find a market solution through share capital increase, trade sale or merger. Failing such a solution the Regulator will invoke the Resolution Trust powers that it ( or a purposely created organization) has to have to take over the institution and gradually wind it down.

The process of resolution will respect the rights of depositors under any State guarantee, force haircuts on bondholders in accordance with their legal ranking rights. If bond holders are not paid in full and have to suffer a haircut the shareholders have to be wiped out.

By adopting this system the market dynamics are changed with management, bondholders and shareholders forced to keep a balance to achieve market driven growth but staying on the right side of regulation to avoid being the last in the qualitative queue.

It would be easier to reach a global agreement on this system rather than on any system with quantitative controls which do not provide for the different circumstances in different jurisdictions. The final qualitative objectives proposed are applicable for all jurisdictions. Failure of the weakest becomes an annual event and like recurring news it would stop being shocking leading to loss of confidence and systemic risk. The too big to fail concept would thus be buried once and for all.

Regulation can only be effective if it is as dynamic as the banking and financial market that it is seeking to regulate. So specific limits and other quantity criteria will unavoidably render regulation far less flexible than the markets; in such circumstances the markets will take over forcing regulators in Greenspan style to surrender and argue that the market can regulate itself. The 2007/2009 crisis proves that the market cannot regulate itself. On the other hand any stringent quantitative regulation, even if it were possible on a global scale, would suffocate recovery and will limit long term growth.

Critics of this proposed system of Regulation with whom I discussed my ideas have expressed reservations on its applicability on the basis that jurisdictions will use different criteria in their respective jurisdictions to identify their weakest performers. I consider this flexibility in approach as a strength not a weakness as it provides for the different realities in different jurisdictions.

What is important for the system to work is not so much the accuracy or uniformity in the process through which Regulators of the varying jurisdictions reach their judgment to classify the financial institutions under their regulatory purview, but the discipline it enforces on the market to adopt better practices to distance themselves from the bottom rank. It also helps to make orderly resolution of the weakest link in the financial system as a regular annual affair, without major crisis and without propagation of moral hazard in the too big to fail concept.

By continually weeding the system from its weakest performers the financial markets are kept healthy and prudent, leading to crisis avoidance rather than crisis resolution.

Alfred Mifsud


2nd February 2010.

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