Archive for March, 2008
Ten Fundamental Issues in Reforming Financial Regulation and Supervision in a World of Financial Innovation and Globalization
Today U.S. Treasury Secretary Hank Paulson presented his proposals for a reform of the system of supervision and regulation of financial markets following the most severe – still ongoing – financial crisis in the U.S. since the Great Depression. And soon the Draghi Commission within the Financial Stability Forum will report its conclusions and proposals for reform of the financial system to the G7 Finance Ministers.
To understand whether the U.S. Treasury proposals make sense one should first analyze what are the problems that an increasingly complex and globalized financial system face and what are the shortcomings of the current system of financial regulation and supervision, in the U.S. and around the world. Only a detailed consideration of such problems and shortcomings can lead to the recognition of the appropriate reforms of the system.So, let us consider in more detail such problems and shortcomings of the financial system and of its regime of regulation and supervision.
They can be summarized in ten points or issues…
Here is an article and interview with yours truly recently published in Investment News. NOURIEL ROUBINI: Superbear says there’s more to come By Janet Morrissey March 24, 2008, Investment News Nouriel Roubini, one of the biggest bears on Wall Street, wasn’t surprised by the fire sale at The Bear Stearns Cos Inc. of New York. He [...]
The events of the last few weeks – including the collapse of Bear Stearns and of other highly leveraged, illiquid and insolvent institutions that are members of the shadow financial system – have shown that non bank financial institutions are at risk of liquidity runs in the same way as banks are. The response of the Fed to this bank-like runs on non-bank institutions has been the most radical change in monetary policy and lender of last resort support by the Fed since the Great Depression: such lender of last resort support has been effectively extended to non-bank broker dealers that are among the primary dealers of the Fed. This radical extension of lender of last resort support to some non-banks has taken three forms: first, the $30 billion lending support that Bear Stearns received as part of its bailout/purchase by JPMorgan; second the new $200 billion facility that will allow all primary dealers to swap some of their illiquid assets (especially agency and private label MBS) in exchange for safe US Treasuries (the new TSLF facility); third allowing such primary dealers to access the Fed’s discount window at same terms as commercial banks (the new PDCF facility).
As it is well known destructive bank runs on illiquid but solvent banks can be addressed via bank holidays; but the risk that such bank holidays (freezing of deposits) may lead to runs on other depository institutions has led – historically – to two alternative ways to deal with bank runs: deposit insurance and lender of last resort support by the central banks. Since these forms of support potentially lead to moral hazard – bankers gambling for redemption and making risky loans and not managing properly liquidity risk – optimal policy management of such banking risks implies that these banking/depository institutions – that benefit from deposit insurance and central bank lender of last resort support – are also subject to strict regulation and supervision of their activities; such regulation and supervision is provided in most countries by the central bank but increasingly we see other models (a unified financial services regulator outside the central bank such as the UK’s FSA or regulation/supervision spread among a variety central or local government institutions as in the US).
Now that some non-bank financial institutions that have been deemed as too-systemically-important to be allowed to fail – i.e. Bear Stearns and non-bank primary dealers – have been effectively put under the lender of last resort support umbrella of the Fed the question arises: shouldn’t these non bank institutions be regulated and supervised in the same way as banks are? I.e. be regulated by the Fed and/or have both banks and non-bank securities firms be regulated by a common new institution? Note that currently US securities firms are supervised/regulated by the SEC and have lower capital standards than banks.
These are most complex and difficult questions that I will address in this note…
The Worst Financial Crisis Since the Great Depression is Getting Worse…and the Need for Radical Policy Solutions to the Crisis
It is now clear that the US and global financial markets are experiencing their worst financial crisis since the Great Depression. And in spite of desperate and radical actions by the Fed this crisis is getting worse. A brief equity rally after the rescue of Bear Stearns, the 75bps Fed Funds and the announcement of new radical and unorthodox lending facilities (allowing non bank primary dealers access to the Fed discount window) has already completely fizzled today with US equities plunging over 2% while the severe crunch in money markets and credit market is becoming much worse.
Let me now flesh out how the crisis is becoming more severe and increasing the risk of the mother of all financial meltdowns…
Since the onset of the liquidity and credit crunch last summer this column has been arguing that monetary policy would be impotent to address such a crunch because, in part, of the existence of a non-bank “shadow financial system”. This system is composed of conduits, SIVs, investment banks/broker dealers, money market funds, hedge funds and [...]
Step 9 of the Financial Meltdown: “one or two large and systemically important broker dealers” will “go belly up”
In my February 5th piece on 12 Steps to a Financial Disaster I predicted – as Step 9 of the meltdown – that “one or two large and systemically important broker dealers” will “go belly up” and that other members of the “shadow financial system” – i.e. non-bank financial institutions that look like banks in [...]
In his Wednesday Financial Times’ column Martin Wolf thoughtfully discusses my recent argument that financial losses of the order of $1 trillion (7% of GDP) may be only a lower bound and that such losses may end up being as high as $1.7 trillion or even $2.7 trillion during this systemic financial crisis.
I agree with him that the highest estimates are “excessively pessimistic”. They were provided as a way to show that, at this point, losses of the order of $1 trillion are only a lower bound – not an upper bound – to financial sector losses, not to argue that $2.7 trillion is “the” most likely outcome. Indeed, the most interesting development in the last few weeks is that estimates of financial losses of the order of $1 trillion – that only a month ago were considered way too pessimistic if not borderline crazy - have now become mainstream. As Wolf put it:
“On March 7, Goldman Sachs economists published an even higher estimate of mortgage-related losses, at $500bn, along with $656bn in other losses, for a total of $1,156bn. The mainstream has caught up.”
So to paraphrase “The Devil Wears Prada” now $1 trillion “is the new size 6!”, i.e. the new mainstream benchmark for expected financial losses. The mainstream has indeed caught up very fast.
But what about the more pessimistic scenarios of even bigger losses? Let us consider next this debate in more detail…
Given the growing turmoil in financial, credit and equity markets my 12 steps scenario to a systemic financial meltdown is becoming more likely by the day; and my estimate that financial losses could end up being at least $1 trillion dollars – considered as an extreme worst case scenario a few weeks ago – is now being endorsed by an increasing number of serious analysts.
Let us consider the details of these seriously worsening financial conditions…
Risk of a systemic crisis is rising: the markets are becoming “utterly unhinged”, the financial system is “broken” and “everybody’s in de-levering mode”
I have been away from blogging most of the week as I have been traveling to Abu Dhabi, Saudi Arabia, Dubai and Turkey.
Certainly concerns about the US economy, the credit crunch, the stability of the US financial system and the plunging value of the dollar are rising even among official authorities (central banks and sovereign wealth funds) that I have met in region in recent days.
Here are some of the spreading financial concerns and rising risks in financial markets…
In a recent analysis I argued that the historical pattern in the last 20 years of low default rates by state and local governments may be seriously tested in a severe recession like the one that the US will experience in 2008. Thus, muni bonds may not be as safe as investors have perceived them to be; and the related view that the monolines’ insurance of muni bonds is a safe and profitable cash cow may soon also be severely tested.
Indeed, there is now evidence that many state/local governments are under serious fiscal and debt strains and that default rates on muni bonds will start to surge.
Let me now elaborate in more detail on the above arguments…