The current financial crisis has solidified the belief among many of the sector's keenest observers that we need to remake the major supports of our financial services infrastructure. Here are some of the pressing issues.
- Who should regulate financial services, and how?
- How should financial firms conduct risk management?
- Is the accounting for financial firms adequate?
- Do the laws and regulations limiting the flows of funds between banking and nonbanking entities need to be modernized?
- When, how, and to whom should we extend the federal safety net?
Extensive evidence supports the belief that fundamental change is needed. There's no denying that the vulnerabilities of our system have been laid bare over the past nine months. The weaknesses of diagnostic and risk mitigation tools have been exposed.Regulatory breakdown. Many of the world's most astute financial leaders thought last summer that the subprime mortgage disruption was a minor matter involving a relatively small class of homeowners. Harsh reality was obscured by a regulatory system that provided neither transparency for nor oversight of the activities and exposures of the vast majority of counterparties in our financial system.
For example, the regulatory community could not or did not stop pervasive, unsound practices in the mortgage brokerage industry, including fraudulent documentation. Every day it is becoming more apparent that these practices will prove toxic not only for subprime and "alt-A" borrowers, but also for many who have been classified as prime credits.
And we are not talking about the occasional scam. We are talking about millions of borrowers and over $1 trillion of lending.
At the same time, regulated institutions — often engaged in the same businesses as the unregulated financial world — are subject to an omnipresent regime. This enveloping system did not spare them from the mortgage crisis, even though it has subjected them to hundreds of millions of dollars of fines and compliance costs that unregulated institutions hardly have to think about.
Such regulatory imbalance creates many problems. The unregulated industry, at least for a time, can produce better returns on equity than the regulated one, thus attracting capital and pushing the regulated industry out on the risk curve to compete.
Risk management and financial modeling. Despite considerable advances, modern risk management has not proven up to the task. Risk managers and other executives could not measure the extent of risk across their enterprises, or they could not value their positions, or they could not control traders, or they were not listened to, or all of the above. Not a pretty sight.
Even now, with institutions starting to engage in self-analysis regarding the financial crisis, we are coming to appreciate the intense strains the mammoth financial services firms have been under. Overseeing multiline businesses over multiple geographies with hundreds of thousands of employees is a herculean task. In this regard, the commendable work certain large institutions have done in examining their own problems, including their inability to integrate risk measurements across the financial services platform, is most revealing.
Accounting systems. Whether or not new rules have produced a clearer picture of financial reality — a highly debatable point — they certainly have created counterproductive volatility. We have found our accounting and other regulations to be almost entirely pro-cyclical. They were instrumental in ensuring that the banking industry went into this crisis with loan-loss reserves that have proven inadequate.
Accounting rules have made acquisitions by strategic buyers more difficult. They have led to financial statements based in part on what the Street refers to as "mark to make believe."
Potential sources of assistance. This should not have been a liquidity crisis. It has become so not only because our financial valuation tools have proven so flawed, but also because we have had to confront a wall of bank and holding company laws and regulations constructed for a bygone era.
For example, entities that have had the money to help resolve problems have been stopped from doing so in as efficacious a way as possible by outdated laws and interpretations. In some cases, investors have not been able to take control of troubled banking organizations and provide the management talent needed to turn them around. In other cases, historic concerns about mixing banking and commerce have actually prevented money from flowing into the financial sector when it has been needed most.
Our laws just have not caught up with the reality that large sources of money — pension funds, private-equity funds, sovereign funds, and other investment vehicles — that are not by any common-sense definition commercial and industrial are being so classified in too many instances.
Extension of the safety net. Thus far the Fed has done a magnificent job heading off a systemic crisis by pouring liquidity into the markets, rescuing one of our largest investment banks from collapse, and buying hundreds of billions of dollars of private-sector paper. However, this kind of effort is not a sustainable way to run the financial system.
Just think of the sacred cows the Fed has had to hobble, if not slaughter, to save our system. Worries about moral hazard, "too big to fail," and the limitations of the federal safety net have taken a back seat to maintaining stability day to day. Certainly there are those who believe, irrespective of the kind of financial entity or its regulation status, that if it is big enough and creates sufficient counterparty risk, the Fed will have to keep it from failing in the end.
Major changes. The Treasury Department has started thinking about the serious changes that need to be made to our financial system in its thoughtful blueprint of a modernized regulatory framework. However, the Treasury blueprint is just a start.
Similarly, Congress and financial trade groups have begun to stir in a positive fashion about these big issues. Congress is happily considering major legislation in the GSE and subprime areas. Yet we need to do much more to address the current crisis and the larger, longer-term issues.
For months we have been mired in a series of small steps and voluntary programs, which involve only regulated institutions for the most part. It is as if the government has been playing poker with the financial crisis, trading a card here and there and doling out a chip at a time, at the last minute, and only when absolutely needed.
First, the administration, Congress, and financial firms must take bold actions now. Whether acting through the FHA, an RTC-like mechanism, or a Home Owners' Loan Corp.-like mechanism, we need to create a bold and broad program to buy hard-to-value paper at market prices, and to keep the maximum number of Americans in their homes with mortgage products that reflect what they can pay. The recently passed American Housing Rescue and Foreclosure Prevention Act (H.R. 3221) takes a big step in this direction.
Second, the president and Congress should convene a bipartisan commission to come up with recommendations for modernizing our financial regulatory and accounting systems. And the president and Congress should commit themselves to act on those recommendations within a set period of time.
Third, individual firms should engage in a full and candid assessment of the failures in their risk management frameworks. They should completely rebuild these systems, ensuring that they are "best in class" in every respect.
If we do not begin to think boldly and make the changes needed to our financial system — if we merely put off the day before we have to make these changes — this crisis will be worse, and the next crisis will be larger. Now is the time to act.
