Risk Part 4: Regulatory Revision

There is widespread consensus these days that the way we, as a society, are dealing with risk is unacceptable. In up business cycles wild profits are made based on risky behavior, and then in down cycles the public has to bail out corporations. The re-regulation process spearheaded by the Basel Committee aims to "align bank capital more closely with the risks taken." To make banks more resilient to market downturns, Basel II proposes the following:

* Set higher capital requirements for certain complex structured credit products.
* Strengthen global practices for liquidity risk management and supervision.
* Initiate efforts to strengthen banks’ risk management practices and supervision, relating in particular to stress-testing and off-balance sheet management.
* Enhance market discipline through better disclosure and valuation practices.

Lots of other suggestions are being made for regulatory revision, many from players in the hedge fund community and financial community. Here's a selection of what I've seen recently:

* Pay bonuses out of the least-desirable assets held by the company. For 2008 year-end bonuses, Credit Suisse gave employees its most illiquid loans and bonds.
* Tax transactions during booms to even out business cycles and to pay for bailouts during busts. Perhaps this should be aimed directly at problem instruments: Steven Allen of Rutter Associates and NYU suggests that "uncollateralized derivative transactions would be subject to a “systemic risk tax” which could be adjusted by regulators until desired risk reductions were achieved. In addition, to aid regulators in overseeing credit extension to hedge funds, a complete database of hedge fund positions would be created to facilitate the assessment of risk concentrations that may not be visible to individual prime brokers."
* Keep some of the risk of loans in each place the loan passes through. Part of the problem in the sub-prime crisis is that the bank that originated the loan was able to pass all the risk on to other organizations.
* Reduce moral hazard - Tie bonuses to long-term profitability, not short-term, so that employees don't have an incentive to maximize bonuses through wreckless investments.
* Mark-to-Market accounting - Modify this accounting standard, such as by changing what counts as a capital charge.
* Scrutinize new products - Have a vetting procedure, akin to health & safety vetting of new drugs, for new financial products.
* Stopper up the loop holes - Make regulations principles-based instead of rules-based.
* Stop using VaR for determining market risk capital requirements. Use stress tests and stop limits instead.
* Change the way we calculate credit risk.
* Raise credit capital requirements for risky products - Such as credit default swap contracts; and any product that is new, complex or opaque.
* Improve the work of rating agencies - the founder of a hedge fund says, "The market perceives the rating agencies to be doing much more than they actually do. The agencies themselves don’t directly misinform the market, but they don’t disabuse the market of misperceptions — often spread by the rated entities — that the agencies do more than they actually do. ...The rating agencies remind me of the department of motor vehicles: they are understaffed and don’t pay enough to attract the best and the brightest. The DMV is scary, but it is just for mundane things like driver’s licenses. Scary does not begin to describe the feeling of learning that there are only three or four hard-working people at a major rating agency judging the creditworthiness of all the investment banks; the agency, moreover, does not even have its own model for evaluating creditworthiness."
* Ensure corporations have better forensic accounting staff to prevent rogue traders.

(I apologise that I've lost some of the links to that material, a hazard of doing my reading on the streetcar.)

Reading what needs to be fixed was shocking to me. I think most of us had no idea how lax the regulations and oversight have been. There is plenty of bureaucracy, but holes in the rules big enough to drive the space shuttle through. Lots of regulatory revision is required, but it's not enough. Some structural changes are needed as well. More on that next.

See also:
Risk Part 1: Issues
Risk Part 2: The Mess
Risk Part 3: Case Study - How Poor Risk Management Caused the Crisis

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