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Rediff.com  » Business » Wall Street has to be pushed further

Wall Street has to be pushed further

By Urjit R Patel
August 18, 2008 14:10 IST
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Against the backdrop of continuing apprehension that another large financial firm will collapse within the next six months on account of the credit crunch, an important report pertaining to the financial sector - Containing Systemic Risk: The Road to Reform - was published last week by the Counterparty Risk Management Policy Group, which comprises representatives from the largest integrated financial institutions. The CRMPG report identifies practically all the major drivers of the current malaise, including "unbridled optimism" (code for greed).

The recommendations are against the background of several precepts that the group has identified: (i) culture of corporate governance to ensure that incentives balance success and disciplined behaviour over the (lending) cycle; (ii) basics of risk scrutiny to allow for monitoring (with short lags) of risk concentrations and providing effective reports to management; (iii) periodic estimating of risk appetite; (iv) focusing on contagion by "brainstorming" to identify "hot spots"; and (v) enhanced oversight by annual meetings between supervisors and the board of directors of the large intermediaries.

In no small part, the credibility of the report is buttressed by suggestions that will be costly to members of the CRMPG. The report is a rare instance of Wall Street hubris giving way to candour; it asserts corporate governance shortcomings as a contributor to the most serious financial meltdown in the US in decades. (The Chair of the group, Gerald Corrigan, the straight talking former head of the New York Fed must have had to knock heads hard.)

Having said this, corporate governance is the only component of the scaffolding of the report that does not have a separate chapter dedicated to it (more detail would have meant washing the laundry in public - after all, there are limits even to forthrightness!).

Several of the recommendations are unexceptionable and long overdue, in particular, accounting consolidation to include disclosures of operations of off-balance sheet activities.

It is suggested that high-risk complex financial instruments should be sold only to sophisticated investors with the associated documentation carrying more information for better risk assessment by counterparties, which includes, inter alia, output from stress tests and health warning about the presence of characteristics that gives rise to the potential for loss over the life of the product.

On the market microstructure front, far-reaching features include establishing a clearing house for credit derivatives, and investment banks required to match trades on the same day.

Regarding risk management, the report makes the right noises in beefing up technological capabilities (reducing lags); exhorting management to ensure regular generation of internal risk reports (presumably, also read them); investment in supervisory capability (doubtless, also to stay awake at the switch); and capital charges linked to complexity of products and the concomitant confidence in meaningful price discovery.

Unfortunately, the report does not countenance widening the scope of transparency in the sector, and it refrains from being prescriptive on some knotty issues that are at the heart of the present crisis. The report also has a fair bit which is not new.

After identifying compensation structures as critical for disciplined behaviour and (implicitly) acknowledging that the risk function is dominated by other (income generating) functions, the report suggests: "large integrated financial intermediaries should aggressively seek out opportunities to rotate high-potential individuals between income-producing functions and support/control functions."

Instead, to change incentives fundamentally, a suggestion could have, e.g. encompassed the following elements: (a) risk personnel compensations need to be ring-fenced, that is, be made independent of profit; and (b) variable compensation for others should be based on value creation over the "life cycle" of individual deals. The latter may not be easy to design, but would not be insurmountable either.

An instance of regurgitating old wine is the recommendation that each institution "ensure that the risk tolerance of the firm is established or approved by the highest levels of management and shared with the board".

The fact is that this is already part of the international regulatory framework (under Basel); the report could have shed light why this important process for managing risk concentration not only failed, but repeatedly so, in diverse institutions in the run up to the crisis.

In addition, broader divulgence of risk models and stress tests is not seriously examined as an option in the report; disclosure to supervisory agencies of these matters is already required (therefore, is not new). Wider stakeholder interest requires transparency beyond sharing information with supervisers (coziness between supervisors and the business end of the sector will have to be squarely faced once US government bandwidth moves beyond fire fighting mode).

The report is sorely unimaginative when it comes to information sharing with the public and the wider research/analyst/academic community; a paradigmatic shift in public disclosure would be "game changing".

Instead, one suspects, that much of what large integrated financial intermediaries do in the future will persist to be a "black box" even as the taxpayer continues to underwrite a seemingly unconstrained financial safety net for the sector.

Finally, an essential undercurrent in the report seeks to protect discretionary freedom of the institutions in carrying out the recommended changes. The report ignores the reality that elbow room on crucial matters is an important dimension in contributing to the problems.

For the financial system to engender confidence (and allay the public's fear of intrinsic fragility) somewhat inflexible and easy-to-monitor rules will have to make a comeback to some extent. With justification, it is widely felt that large financial institutions can get away by not consistently following good conduct in their businesses due to discretion vested in extant "soft" principles in conjunction with the leeway in interpretation granted to supervisors in their work.

While the CRMPG report will be invaluable for a systemic remake of policy in the sector, regulators at the minimum should either discount some suggestions, or, put flesh on recommendations that carry a "trust our judgement to put the house in order" overtone. In this business, evidence is robustly tilted towards: "self regulation is, eventually, no regulation!"
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Urjit R Patel
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