We know that the regulatory structure of our financial system is about to change. When I originally wrote this column earlier in the month, Congress was struggling to approve some sort of “rescue” package, with both the House and Senate reworking the first $700 billion plan that didn’t pass muster. Now we have a rescue plan, but the details remain vague. Whatever the final outcome, we can expect to see an entirely new financial system-wide regulatory structure.
Clearly the existing regulatory system has not met the needs of the 21st century’s capital markets. Crafting a new structure will take many months and will be a highly contentious process. We can, however, right now envision a broad outline of how such a system should look.
To fix any system, it’s necessary to know why the existing system broke down in the first place. My February 2008 column points to what went wrong with the system participants, with plenty of blame to go around. Fingers point to firm managements, mortgage generators, borrowers, credit rating agencies, regulators, and insurance companies, among others.
But people much more insightful than I identified the pending disaster long before me. Warren Buffett described credit default swap type contracts as “ticking time bombs,” and at least one Federal Reserve governor and a senior Treasury official warned years ago of looming problems.
A recent speech by FASB Chairman Bob Herz offers further insight into lessons we need to learn (and relearn) from past and recent failures. He noted that the crux of the problem were non-traditional loans, based on questionable mortgages and structured into “an increasingly complex array” of securities sold and re-sold to other investors. “These institutions and investors … apparently saw little need to conduct their own due diligence, risk management, modeling, and valuation processes. And as the music grew ever louder, the dance, premised on an apparent belief that U.S. home prices would continue to rise or at least not decline, became ever more frenzied.”
And most on point to this column, Herz said: “Unfortunately, balkanized regulatory systems, both in the United States and across international financial markets, may have made it difficult, if not impossible, to rein in the exuberance driving the markets. And just as in the savings & loan crisis, regulators apparently failed to fully understand the risks their regulatees were taking on, and apparently thus saw little reason to try to curb what turned out to be mounting problems.”
Central to this message, and that of Congressional leaders and others, is what now has become all too clear: our regulatory architecture needs to be completely revised. Treasury Secretary Hank Paulson has provided a blueprint for the future, and there undoubtedly will be other proposals as well.
Moving Forward
Understandably, lots of people are angry at what’s happened to our financial system and markets. The disarray has had serious consequences both at the national level and at very personal levels for individuals and families. Understanding what went wrong, and by whom and why, is critical to establishing a new regulatory system that truly works. From my perspective, we need a system that has certain basic characteristics:
Deal with interconnectivity. A telling term these days is “interconnectivity,” and dealing with this reality must be central to the structure and workings of a new regulatory system. The existing system became critically ill in part because of the tremendous volume of transactions and related counter-party interrelationships among participants. It’s been decades since we’ve had clearly defined firms acting independently, but regulators have not sufficiently reacted to the financial world that changed long ago.
Integrate the system. The “balkanized” regulatory structure must be scrapped. With different players each able to wreak havoc on the entire financial system, regulators must be organized to deal with the system in its entirety. The scope needs to include banks, investment banks, broker dealers, insurance companies, hedge funds, and other firms. We must have either one regulator overseeing the entire system, or a hierarchy of agencies each with its own clear scope but working together to share information and ensure action is taken to keep the system functioning well.
Understand the risks. Risks related to existing sophisticated financial instruments, and those that will emerge, must be well understood by regulators. Regulators need to understand these instruments and transactions individually, as well as how they can affect an individual firm, its trading partners, and the system as a whole. Risks to the system need to be handled aggressively, heading off activities before they become too large and dangerous.
Set clear protocols. The regulatory system should be designed, staffed, and function in a manner to head off major problems before they occur; but should a firm become endangered, regulators must have clear protocols regarding what to do. We no longer can tolerate ad hoc action, deciding on the fly whether a firm should be bailed out, forced into an acquisition, or allowed to go under.
Ensure adequate resources. Regulators must have the leadership and staff to ensure they stay abreast of what’s happening in the real financial world. They cannot afford to play catch up to some of the brightest and most innovative players on the planet, who craft strategies and products to create wealth for their customers, clients, and themselves. Regulatory authorities must be able to understand the activities and implications of the firms they are regulating.
Deal with the next crisis. Of one thing we can be certain: When the next financial crisis arises, it will be caused by factors different than what we currently face. A new regulatory system must be geared to deal with new risks as they surface, and to take the action necessary to avoid a disaster.
Encourage innovation and wealth generation. While the regulatory system must recognize on a real-time basis exactly what is going on in the system, it nonetheless should allow and encourage the kind of innovation that has provided an improved standard of living and wealth for our citizens. At the same time, it must know early on exactly what the financial system participants are doing that could badly damage major portions of the system or the system in its entirety.
Encourage international cooperation. Reality is that the world is interconnected (ah, this word crops up once again!). This is true with regard to where financial firms operate, as well as where shares are traded and transactions executed. It is imperative that there be good international cooperation to do the best possible job to ensure a financial crisis in one part of the world doesn’t bring down everyone else.
We can hope that the next Administration and our Congressional leaders put political and ideological differences sufficiently aside in taking needed action. Yes, there are fundamental philosophical differences, and there must be a balance between allowing positive innovation and restricting activities that can put us on the precipice. Free enterprise must be encouraged and nurtured, working within a system that monitors and understands what is happening and is reasonable in protecting overly aggressive firms from themselves, as well as protecting investors and the system as a whole.
But we cannot wait very long. Too often we’ve seen that once an immediate crisis has past, our government representatives move on to what are considered more pressing matters. And, it’s always easier to deal with short-term issues. This is one area, however, where we cannot afford to be complacent. Washington needs to get on this—and do it reasonably quickly and do it right so that our country can put this mess behind us, and get our future back on track.
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