Concorde’s fate offers a lesson for finance

Published in the Financial Times on April 15 2009

The supersonic Concorde aircraft was considered in the 20th century to be the most sophisticated airliner, flying at twice the speed of sound. Its crash in Paris on July 25 2000 destroyed this confidence. Some blamed the crash on metal fragments from another aircraft; others argued that Concorde was overweight and unbalanced. The accident led to some design modifications but in 2003 Concorde was in effect jettisoned in favour of subsonic aircraft, much slower but easier to maintain.

It is not too much of a stretch to compare the global financial system of the pre-subprime era to Concorde. It was fiercely innovative and grew at a record pace for close to two decades, only to suffer a new type of hard landing without clarity as to whether it was the fault of the system’s pilots or also of those regulating its maintenance.

Restoring Financial Stability

How to Repair a Failed System…

There are many cracks in the financial system, some of which we now know, others no doubt we will discover down the road. The eighteen white papers and executive summaries of each chapter of New York University Stern School of Business book, “Restoring Financial Stability: How to Repair a Failed System”, forthcoming this March by John Wiley & Sons, and contributed to by 33 of our faculty members, describe a relevant issue at hand and corresponding regulatory proposals. A common theme of our proposals notes that fixing all the cracks will shore up the financial house but at great cost. Instead, by fixing a few major ones, the foundation can be stabilized, the financial structure rebuilt, and innovation and markets can once again flourish.

Why government guarantees are a double-edged sword

As the search goes on for culprits and remedies in the global financial crisis, not enough attention has focused on the role played by governments in explicitly or implicitly guaranteeing the banking system.The massive bank bailouts now being undertaken across the industrial world make the point: governments can not allow banks to fail for fear that the collapse of one will provoke a systemic crisis. By extension, we would contend that government guarantees played a central role in creating the mess in the first place, and that reforming them will be key to preventing a recurrence.

Chapter 18: Executive Summary – International Alignment of Financial Sector Regulation

From the book “Restoring Financial Stability: How to Repair a Failed System”. Section VII: International Coordination

Background

Many of the policy recommendations being put forward to repair national financial architectures will prove to be ineffective – or at least their edge blunted – if there is a lack of international coordination among central banks and financial stability regulators in implementing them.  This issue is important; although cross-border banking and financial flows are extensive, much of bank and financial supervision remains national. There is some consensus on prudential aspects of regulation such as capital requirements and their calculation, but there is hardly any consensus on the core set of principles driving the regulatory stance to providing guarantees and intervening in markets and banking sector.

Chapter 15: Executive Summary – The Financial Sector “Bailout”: Sowing the Seeds of the Next Crisis?

From the book “Restoring Financial Stability: How to Repair a Failed System”. Section VI: The Bailout

Background The two-month period from September to November 2008 has been witness to the most extraordinary level of direct US governmental involvement in financial markets in over seven decades. In part, this intervention took on the form of ad-hoc institution-specific rescue packages such as those applied to Bear Stearns, Fannie Mae, Freddie Mac, AIG, and Citigroup. But a substantial part of the effort and huge sums of money have also been committed in an attempt to address the systemic problems which led to the freezing of credit markets. A multi-pronged approach has finally emerged with three key schemes:

  1. A loan-guarantee scheme administered by the Federal Deposit Insurance Corporation (FDIC) under which the FDIC guarantees newly-issued senior unsecured debt of banks out to a maturity of three years.
  2. A bank recapitalization scheme undertaken by the US Treasury in which the Treasury purchases preferred equity stakes in banks.
  3. A commercial paper funding facility (CPFF) operated by the Federal Reserve.

Chapter 14: Executive Summary – Private Lessons for Public Banking: The Case for Conditionality in LOLR Facilities

From the book “Restoring Financial Stability: How to Repair a Failed System”. Section V: The Role of the Fed

Background

As we work our way through the current financial crisis, central banks have shifted their attention from managing short-term interest rates to providing liquidity to the financial system.  In the US, for example, the Federal Reserve’s balance sheet has expanded rapidly, as it offered funds to banks and accepted securities in return: from under a trillion dollars in August 2007 to over two trillion in November 2008, expanding primarily through its lending to banks against illiquid collateral.  This “lender of last resort” (LOLR) role is neither new nor unusual, but its massive scale suggests that it is worth some thought to get the details right.  We make below what may seem right now to be a perverse argument:  Central banks can learn something from the private sector about how to manage its provision of liquidity.

Chapter 13: Executive Summary – Regulating Systemic Risk

From the book “Restoring Financial Stability: How to Repair a Failed System”. Section V: The Role of the Fed

Background Systemic risk is the risk that the failure and distress of a significant part of the financial sector reduces the availability of credit which in turn may adversely affect the real economy. Not all economic downturns involve systemic risk, but the occurrence of systemic risk has almost invariably transformed economic downturns into deep recessions or even depressions.  Such systemic risk has been ubiquitous in the current crisis. It has manifested itself in the moral hazard encouraged by “too-big-to-fail” guarantees, in the externalities created by deleveraging, fire-sales, hidden counter-party risk and liquidity shortages, and in the aggregate decline in home prices.

Chapter 11: Executive Summary – Centralized Clearing for Credit Derivatives

From the book “Restoring Financial Stability: How to Repair a Failed System”. Section IV: Derivatives, Short Selling and Transparency

Background

Credit derivatives, mainly Credit Default Swaps (CDS) and Collateralized Debt Obligations (CDOs), have been under great stress during the sub-prime financial crisis and have contributed significantly to its severity.  In large part this is because these relatively new products are traded in bilateral transactions over-the-counter (OTC), unlike other major financial derivatives that are traded on exchanges.  OTC contracts can be more flexible than standardized exchange-traded derivatives, but they suffer from greater counterparty and operational risks, as well as less transparency.

Chapter 10: Executive Summary – Derivatives – The Ultimate Financial Innovation

From the book “Restoring Financial Stability: How to Repair a Failed System”. Section IV: Derivatives, Short Selling and Transparency

Background

Derivatives are financial contracts whose value is derived from some underlying asset. These assets can include equities, bonds, exchange rates, commodities, residential and commercial mortgages. The more common forms of these contracts include options, forwards/futures and swaps. A considerable portion of financial innovation over the last 30 years has come from the emergence of derivative markets. Generally, the benefits of derivatives fall into the areas of (i) hedging and risk management, (ii) price discovery, and (iii) enhancement of liquidity. Even in the current financial crisis, the derivative scapegoat, credit default swaps (CDS), has played some positive roles. For example, CDSs enabled lenders to hedge their risk and offer loans. When the securitization market for loans, bonds and mortgages shutdown in the summer of 2007, a number of financial institutions were left holding large loan portfolios. Using the CDS market, some of these financial institutions smartly hedged out their risk exposure. In addition, CDSs and other credit derivatives have played a very important role in disseminating information to both the public and to regulators: from judging the quality of financial firm’s bankruptcy prospects in a remarkably prescient way, from providing credit risk estimates that were central to the U.K. government’s bailout plan, and from revealing in early 2007 declines in values of subprime-backed assets.

Chapter 7: Executive Summary – Corporate Governance in the Modern Financial Sector

From the book “Restoring Financial Stability: How to Repair a Failed System”. Section III: Governance, Incentives and Fair-value Accounting

Background

The large, complex financial institutions (LCFIs) are highly levered entities with over 90% leverage. This highly-levered nature makes them prone to excessive leverage- and risk-taking tendencies.  By and large LCFIs also have explicit deposit insurance protection and almost always an implicit too-big-to-fail guarantee.  The presence of such guarantees – often un-priced and at best mis-priced – has blunted the edge of the debt monitoring that would otherwise exert an important market discipline on risk-taking by these firms.  Although there is mounting evidence pointing to weaknesses in equity governance of these firms, the high leverage they have undertaken and the failure of their internal risk management practices also suggest weakness and failure of regulatory governance.