LONDON -- Major industrial nations should undertake a comprehensive review of financial regulation and supervision, according Henry Kaufman, a New York-based money manager and economic consultant.
Speaking in London last week, Mr. Kaufman said that the rapid expansion of trading in derivatives has led to a "definite weak spot in official supervisory organizations and capabilities."
The economist, who gained renown for his pessimistic predictions about rising interest rates when he worked for Salomon Brothers in the early 1980s, is the latest prominent financial figure to warn about the dangers inherent in derivatives trading.
Prompt Action Urged
He emphasized that a new commitment to financial regulatory and supervisory reform should be made while financial markets are still relatively calm and there is no crisis to be dealt with.
"Continuing to put that off until some unforeseen shock exposes those inadequacies could inflict a great deal of financial pain and cost," he said.
Mr. Kaufman stressed that one of the main reasons the current regulatory system is inadequate is because it was designed for a segmented and compartmentalized financial world that no longer exists.
The economist added that although he recognized the benefits of financial derivatives including futures, forwards, interest rate and currency swaps, and related options, the risk involved with financial derivatives - not only the risks to individual participants but the broader risks to the economy and the financial system - may not be fully appreciated, either by market participants or by official financial supervisors and regulators.
List of Recommendations
Mr. Kaufman made six recommendations to improve the regulatory system and deal with the expansion of derivatives trading and related issues.
* Bring together banking securities and insurance regulators to harmonize accounting, disclosure, and trading standards to reduce differences between countries.
* Extend regulatory coverage to financial institutions that are current unregulated, such as finance companies. If this is not done, Mr. Kaufman warned, there will likely be a shift in business away from regulated entities and the safety and soundness of the financial system will suffer.
* Clarify regulatory oversight of securitization and bring securitized credits under regulatory supervision.
* Strengthen capital standards with regard to evaluating market risk and risks associated with off-balance sheet activities.
* Reach an international agreement on the investment powers of universal banks.
*Establish a new international institution that would serve as the focal point for regulatory harmonization, possibly by creating a separate board that would oversee major international institutions and markets.
Trend to Permissiveness
Mr. Kaufman pointed out that the growth of financial derivatives is part of a long-standing movement toward permissiveness in financial regulation, technology-driven financial innovation, massive securitization of mortgages and other products, sweeping internationalization of trading in currencies, bonds, and equities, and a shift toward institutionalizing portfolio investment.