The ERM Current™

Last week, a high-profile group of investor advocates published a report that provides practical recommendations on how to reform the U.S. financial regulatory system.  Known as the Investors’ Working Group (IWG), this independent, non‐partisan panel was formed to provide an investor perspective on ways to improve the regulation of U.S. financial markets.  The group is led by former SEC chairmen William Donaldson and Arthur Levitt and, among other things, recommends establishing a Systemic Risk Oversight Board rather than placing this responsibility in the hands of the Federal Reserve.  Here is a summary of their proposals.

1. Designating a systemic risk regulator, with appropriate scope and powers. One option would be for the Systemic Risk Oversight Board to evolve into a full‐fledged regulator.
2. Adopting new regulations for financial services that will prevent the sector from becoming dominated by a few giant and unwieldy institutions. New rules are needed to address and balance concerns about concentration and competitiveness.
3. Strengthening capital adequacy standards for all financial institutions. Too many financial institutions have weak capital underpinnings and excessive leverage.
4. Imposing careful constraints on proprietary trading at depository institutions and their holding companies. Proprietary trading creates potentially hazardous exposures and conflicts of interest, especially at institutions that operate with explicit or implicit government guarantees. Ultimately, banks should focus on their primary purposes, taking deposits and making loans.
5. Consolidating federal bank regulators and market regulators. Regulation of banks and other depository institutions may be streamlined through the appropriate consolidation of prudential regulators. Similarly, efficiencies may be obtained through the merger of the SEC and the Commodity Futures Trading Commission (CFTC).
6. Studying a federal role in the oversight of insurance companies. The current state‐based regulation makes for patchwork supervision that has proven inadequate to the task.

This report offers a middle path on many issues under debate today and may prove to be the best way forward for all involved.

This week, the Washington Post revealed that the U.S. Treasury has launched an internal effort to determine the size and nature of credit risk across the U.S. financial system.  The effort is portrayed as the development of a last-ditch plan to understand the full scope of credit risk and where it resides.  Here is how the Post described the effort.

Informally known as Plan C, the internal project is focused on vexing problems such as the distressed commercial real estate markets, the high rate of delinquencies among homeowners, and the struggles of community and regional banks, said government sources familiar with the effort.

Part of the mission is assessing which firms are the most vulnerable and trying to decipher what assets these companies hold and whether they pose a danger to the wider financial system. Plan C is a small-scale, relatively informal approach to a problem the administration hopes to address in the long term by empowering the Federal Reserve to oversee systemic risk.  The creation of Plan C is a sign that the government has moved into a new phase of its response, acting preemptively rather than reacting to emerging crises, officials said.

This revelation is somewhat disturbing and promising at the same time.  It is disturbing that the government is just now beginning to work on an effort such as this, but promising in that they are working to prevent future problems rather than just cleaning-up after the fact.

This week the U.S. Senate Committee on Homeland Security and Governmental Affairs conducted a hearing on how systemic risk needs to be governed by our financial regulatory agencies.  All agreed for the need of a single regulator, but there was not unanimous agreement on who should serve in the role.  Most point to the Federal Reserve given their role as the lender of last resort.  However, a few fear the increased level of political influence on the Federal Reserve given that they are the central bank for the United States.   Here is the view of Robert Pozen, Chairman of MFS Investment Management and Senior Lecturer at Harvard University.

1. The United States needs one federal agency to play the role of systemic risk regulator because of the increasing frequency of global financial crises and higher correlations among different investment markets.

2. Congress should give this role to the Federal Reserve Board because it has the job of bailing out financial institutions whose failure would threaten the whole financial system.

3. The Federal Reserve Board should focus on five areas that are likely potential sources of systemic risk – inflated prices of real estate, institutions with high levels of leverage, new products falling into regulatory gaps, rapid growth in an asset class or intermediary and mismatches of assets and liabilities.

4. The Federal Reserve Board should monitor closely the activities of all types of financial institutions with very large or otherwise very risky assets since they are the ones most likely to impact the whole financial system.

5. If the Federal Reserve believes that actions need to be taken to reduce systemic risks, it should work closely with the regulatory agency with primary jurisdiction over the relevant institution, product or market.

Senator Joe Lieberman, chairman of the committee holding the hearing, said lawmakers have a large task in redesigning financial regulation, which is now broken. ”We cannot expect the creation of a systemic risk regulator to be a universal remedy for all that ails our financial services industry today,” Lieberman said. “As always, the devil is in the details.” 

Back in September, one of the first posts to this blog focused on the systemic risk failure that led to the current financial crisis.  The systemic risk discussed was related to the use of derivative instruments such as credit default swaps (“CDS”) to mitigate credit risk associated with corporate debt.  The rapid increase in use of these CDS instruments combined with the lack of regulatory oversight led to a dramatic increase in systemic risk that has not been well managed.  A recent article by Institutional Risk Analytics provides a great example.

The basic tension over CDS starts with the fact that these instruments actually increase overall systemic risk. 

Consider a real world example: When the auto parts make for General Motors, Delphi, filed bankruptcy in October 2005, there were between $20 and $30 billion in CDS outstanding and deliverable against the $2 billion in debt outstanding and another $2 billion in bank loans that were also deliverable against the CDS.  Whereas the maximum cash loss to investors in the Delphi default might have been limited to the $4 billion of extant debt without CDS, the existence of CDS actually multiplied the potential opportunities for gain and loss on the Delphi default nearly 10 fold. 

While proponents of the CDS market will and do argue that the “net” exposure from the Delphi default was quite small, the fact remains that the “innovation” of CDS actually created a multiplicity of new risks around the existing cash default of Delphi, risks whose sole benefits seem to be a) providing speculative opportunities for a certain class of market participants – I won’t call them investors, because often they are not — and b) generating commission for CDS dealer banks.

A great deal of work must begin immediately to address this situation that is at the core of our economic meltdown.  While potential solutions have been discussed, no real steps have yet been taken by the public or private sector.  However, as we all know too well, risk waits for no one.

The sudden about-face in the direction of the US Treasury’s Troubled Asset Relief Program (“TARP”) has brought on new fears of increasing systemic risk in the financial markets.  TARP was originally intended to lower systemic risk by ridding the markets of the toxic securities that currently plague the balance sheets of numerous financial institutions.  By leaving those securities on the balance sheets, many believe that a crisis in confidence will re-emerge.  Bloomberg.com noted the following comments yesterday from a credit strategist at BNP Paribas,

“Substantial risk still remains within the U.S. financial system,” said Rajeev Shah, a London-based credit strategist at BNP Paribas.  ”Uncertainty about existing troubled assets could lead to increasing systemic risk.”

Where do we go from here?  Who knows?  However, one thing is certain.  Changing plans in mid-stream is certainly no way to reduce uncertainty in the financial markets.

If you have been following The ERM Current™ over the past few weeks, you will probably recall discussions about systemic risk permeating the financial markets.  Well, yesterday the Wall Street Journal chronicled the making of the engine that fueled the systemic risk.  Much of the credit derivative problem emanated from AIG and their use of sophisticated computer models to value the risk within each of their financial products. An academic consultant from Yale University promoted these models and was paid handsomely for it.  His name is Gary Gorton and here is what he had to say just last month.

“You have this very, very complicated chain of the movement of the risk, which made it very opaque about where the risk finally resided. And it ended up residing in many places. So the whole infrastructure of the financial market became kind of infected, because nobody knew exactly where the risk was.” 

The primary objective of these financial products was to be “opaque” so investors would unwittingly buy into the scheme.  However, when the institutions who peddled these products placed their faith in the computer models to value the risks, their fate was sealed.