The G-20 held its summit in Cannes on managing risk in the global economy in early November. The group of heads of state covered the broad policy and political issues, financial ministers spoke on the difficulty of legislating rules and preventing unintended consequences.
Ultimately they had one goal in mind: preventing financial institutions from being infected with the contagion of systemic risk. It was clear that the financial system's risk management methods must be repaired and data transparency assured, but it was not clear how to do it while balancing each daily financial crisis with the longer-term goals.
Here are a few logical steps to follow toward permanent financial infrastructure reform:
- The G-20's new Financial Stability Board needs to get up and running quickly and has to be given a more proactive implementation role, with resources and funding to match. The FSB needs to be at the center of global reforms, standardizing and pushing out what’s agreed to through sovereign regulators, not the other way around as is now the case.
- Cross-margining of clearing house deposits must be put in place before swaps and other former OTC derivative products are placed in central counterparties.
- The idea of allowing forms of contingent capital for financial institutions should be extended to clearing houses, some of which may also be deemed too-big-to-fail. Private equity should be encouraged to provide a call on their capital as a final layer between exhausting clearing house capital and calling upon the government to bail them out. Significant returns were earned by the government on Tarp funds.
- Investment banking and proprietary trading should return to its roots as partnerships encouraged by carried interest capital gains treatment. Value creation for publically owned banks or other financial institutions can be accommodated by simple client business relationships with these private entities for prime brokerage, trade execution, and clearing services. The top and bottom lines of the banks offering these services would be preserved excepting the liability of capital depletion would be external, to be born by the partnerships.
- Incentive compensation must be risk weighted, with global standards for those risk weightings set, similar to asset risk weights for capital standards
- Current risk management methods based on historical losses and statistical methods needs a parallel method, one that provides for pro-active risk management, detecting risk exposures as they build up. The FSB should encourage experiments and provide incentives for improved methods and systems.
- A globally unique identification system starting with financial trade counterparties, then derivatives product identifiers, needs to be put in place quickly. Without this financial transaction transparency is not possible and systemic risk will not be observable.
- Systemic risk analysis will require a different approach to data gathering and aggregation then is currently contemplated. Gathering the required position, cash flow and pricing data and sending it daily to a government run data center won't cut it, even if it's a single data center and the data is supplied in standard form and content. Any such data center, and there will probably be many, will be overwhelmed with reconciling data, adjusting details as left out trades, missing new account and product identifiers.
- Stress test scenario analysis must be given precise guidelines independent of political interests or country or firm idiosyncrasies. I am sure scholars, retired practitioners and former policy professionals would find it satisfying to assist in crafting and continually modifying such guidelines. They could be something like global ombudsmen, beholden to no vested interests or political agenda. For example, stress tests should not exclude sovereign assets because of lack of political will.
- The notion that a living-will will be able to guide regulators of too-big-to-fail institutions in dismantling or recovering them from a serious capital depletion or failure is whimsical at best. It is a deflection by regulators and legislators from any practical way to deal with these giant globe spanning institutions failing. Who among us from CEO to auditor can describe in detail all the tangible and intangible assets of these firms (people, systems, facilities, positions, transactions, intellectual property, et al), their relationships to each other and to outside vendors, investors and clients to properly define the possessions to be distributed. How can anyone describe all this and a plan to disburse them when we cannot even describe the legal entities of the firms and their hierarchy of ownerships?
- Originating and securitizing mortgages has to be restarted, but first "Ninja" (No Assets, No Job nor Assets) loans need to be banned. Then standard at-origination documents must be the law of the land, like IRS form 1040 and its supplements. A first priority would then be to develop a mortgage origination XBRL taxonomy for the "MOXT form 1040" like we now have for SEC financial statement filings. Traceability and auditability will follow naturally.
- Rating agencies have to be placed in the same penalty box as derivatives construction engineers and risk modelers — it's not an exact science. So why have their pseudo mathematically derived judgments been afforded special status in the law. If we can substitute a general fiduciary duty to be a prudent investor in the law it will foster many new ways to think about judging risk. Better to provide public data to all on defaulted investments, bankrupt companies and collapsed sovereigns and let the world's academics, practitioners and entrepreneurs find better ways. One can envision many toiling at perfecting Monte Carlo simulations of all the possible default paths under a multitude of scenarios. Better to rely on all the views to inform your judgment than rely on a judgment call by any one person or committee at for-profit rating agencies.
Nothing short of re-engineering our financial institutions will do. The Rube-Goldberg-like way these firms evolved — no blueprint, and strategies built on false assumptions, resulted in their not being understood by anyone, CEOs and regulators alike. They cannot be managed to mitigate the risks of a globally connected financial system.
More contagion will surely come to infect the system if nothing is done to address the systemic problems permanently. This will take time, not the pause advocated by others to suit the short-term, Dodd-Frank regulatory agenda. Funding is needed for a series of "shovel ready" infrastructure projects to rebuild our financial institutions and provide a lasting risk adjustment framework That framework needs to keep up with the global spread of our financial system and the global nature of the contagion of systemic risk.
Allan D. Grody is the president of Financial Intergroup Holdings Ltd. He is a founding editorial board member of the Journal of Risk Management in Financial Institutions.