The ERM Current™

Today, the U.S. House Financial Services Committee will welcome several experts to debate financial regulatory reform approaches.  Paul Volcker, former Federal Reserve Chairman and current Head of the President’s Economic Recovery Advisory Board, will testify first by offering his views on how reforms should be enacted.   Here is an excerpt from his prepared testimony.

Important parts of the Administration’s proposed reforms can be – and some are being – implemented and enforced under existing authority. The Treasury has set out principles for capital and liquidity standards. Other prudential approaches are under consideration. Most notably risk management practices, for banks and certain other regulated institutions have been placed under urgent review. At the supervisors’ initiative, useful and needed steps are being taken to encourage more prudent compensation practices.

These are needed steps toward a stronger reformed financial system. However, I want to emphasize two inter-related issues of fundamental importance that run across the more particular elements of reform. One is a matter of broad regulatory practice: how to deal with the insidious, potentially risk-enhancing, spread of “moral hazard”, the presumption that systemically important institutions may be protected in the face of imminent failure. The overlapping question is one of administrative responsibility: in particular the appropriate role of the central bank (the Federal Reserve) in regulation, supervision and oversight of the financial system.

Mr. Volcker has defined the problem very well.  The answer lies in the need to decelerate the consolidation of financial institutions and accelerate the consolidation of regulatory oversight.  Just the opposite has occurred over the past few decades and led us to the brink of financial collapse.

Former Federal Reserve Chairman Paul Volcker recently provided some interesting insight into the role of mark-to-market accounting in the current economic crisis.  In a speech to the International Institute of Finance, Mr. Volcker noted the following.

There isn’t much doubt that attempts to enforce strict application of mark-to-market accounting procedures has contributed to confusion, uncertainty and inconsistencies among financial institutions. There is a strong case for reviewing the application of so-called fair value standards to commercial banks, insurance companies and perhaps certain other regulated financial institutions.

The problem is not only the difficulty of measuring value in highly disturbed market conditions. More broadly, strict mark-to-market accounting — entirely appropriate for trading operations and investment banks — may introduce a degree of volatility in reporting incompatible with the basic and essential business model of banks, which inherently intermediate maturity and credit risks.

There is no doubt that mark-to-market accounting contributed to the death spiral of many institutions as they tried to mark positions to a market that temporarily ceased to exist.  While mark-to-market accounting is noteworthy in its attempts to provide greater transparency, it currently possesses some very serious unintended consequences that must be rectified.

Last week, a document was released by the Group of Thirty that provides some interesting ideas and insight into the future of our financial regulatory system.  For those unfamiliar with the Group of Thirty, it is a private, nonprofit, international body composed of very senior representatives of the private and public sectors and academia that aims to deepen understanding of international economic and financial issues, to explore the international repercussions of decisions taken in the public and private sectors, and to examine the choices available to market practitioners and policymakers.  Notable members of the Group of Thirty include Paul Volcker, Tim Geithner, and Lawrence Summers – all future members of the Obama Administration.  

The document is entitled “Financial Reform: A Framework for Financial Stability” and provides recommendations for improving our financial system once we have moved beyond the immediate financial crisis we are in today.  Of particular interest to readers of this blog are the following set of recommendations focused on governance and risk management. 

Regulatory standards for governance and risk management should be raised, with particular emphasis on:

a. Strengthening boards of directors with greater engagement of independent members having financial industry and risk management expertise;

b. Coordinating board oversight of compensation and risk management policies, with the aim of balancing risk taking with prudence and the long-run interests of and returns to shareholders;

c. Ensuring systematic board-level reviews and exercises aimed at establishing the most important parameters for setting the firm’s risk tolerance and evaluating its risk profile relative to those parameters;

d. Ensuring the risk management and auditing functions are fully independent and adequately resourced areas of the firm. The risk management function should report directly to the chief executive officer rather than through the head of another functional area;

e. Conducting periodic reviews of a firm’s potential vulnerability to risk arising from credit concentrations, excessive maturity mismatches, excessive leverage, or undue reliance on asset market liquidity;

f. Ensuring that all large firms have the capacity to continuously monitor, within a matter of hours, their largest counterparty credit exposures on an enterprisewide basis and to make that information available, as appropriate, to its senior management, its board, and its prudential regulator and central bank;

g. Ensuring industrywide acceptance of and action on the many specific risk management practice improvements contained in the reports of the Counterparty Risk Management Policy Group (CRMPG) and the Institute of International Finance.

These are great recommendations that will certainly strengthen the governance and risk management of our financial institutions.   However, implementation of these recommendations will take a great deal of effort and time.  The sooner we can begin to address these recommendations, the better.