2.1 Transform Financial Firm Incentive Structures that Induce Excessive Risk-Taking

Without solving this key problem of asymmetric and perverse incentives, it might not be possible to create an effective regulatory regime. The reason that bankers take excessive risk in the boom is they do not have to give the bonuses back when their actions crash the firm. Indeed, the high paid deal makers continue to get surprisingly large bonuses. Thus, they win big in the boom and win small in the crash. Meanwhile, the government always tries to keep the crash in check. Regulation must create time consistency: the bankers get the bonus ex post, when it is clear that the gains are permanent. One mechanism to make the payoff structure more symmetrical, and thus reduce incentives for risk-seeking, would be to implement “clawbacks” through which excessive salaries and bonuses paid during the upturn would have to be repaid in the downturn.5 Such clawbacks could be required in compensation contracts or could be implemented via the tax system, through a series of escrow funds and limitations on deductions from losses. Of course, there would be great incentives to engage in tax or restriction avoidance as is always the case. The appropriate response is not to stop trying to use appropriate taxes, but to enforce the tax laws more vigorously. Incentives to ratings agencies also need to change. If they were paid by institutional investors or associations of security buyers rather than the investment banks who sell complex products, the incentive to give excessively optimistic ratings would be eliminated. Alternatively, the government could create independent public ratings agencies that might function in a manner similar to the Government Accountability Office.

2.2 Implement Lender-of-Last-Resort Actions with a Sting

Institutions might be too big to fail, but no chief executive officer (CEO) should be. The CEOs of the seven largest investment banks received a total of $3.6 billion from 2004-07, yet the market capitalisation of their firms declined by $364 billion from their peak values, an average fall of 49%. As long as there is financial capitalism, there will be a need for some lender of last resort bailouts, even if all of these proposed policies are implemented. But a key distinction must be made between the financial institution itself and the agents who made the decisions to take risks and benefited from them – top management, key traders and other richly rewarded operators. These rainmakers must be made to pay significantly when their firms are bailed out. As things currently stand, the perverse incentives embodied in financial firms’ asymmetric reward structure are underwritten by the central bank, which creates extreme moral hazard.

3.1 Extend Regulatory Over-Sight to the ‘Shadow Banking System’

The “shadow banking system” of hedge and private equity funds and bank-created SIVs had become increasingly powerful. Though humbled by the current crisis, it is nonetheless still very much alive, waiting in the wings to revive if and when the crisis is over. This “shadow banking system” played a key role in creating

90 the conditions that led to the global crisis. These institutions must be brought under adequate regulatory control. Investment banks also played a crucial role in the NFA and bear substantial responsibility for creating the current crisis. Though the Federal Reserve does not regulate them, it was forced to bail them out. Dangerous risk-taking caused the big five independent investment banks to disappear in the crisis; two went bankrupt, one was taken over by a commercial bank, and two converted themselves from investment banks to financial conglomerates. The SEC was responsible for regulating investment banks, but it required only voluntary compliance with its rules and never even read the compliance reports submitted by the banks – yet another example of “phantom” regulation. Investment banks need to be tightly regulated.

3.2 Restrict or Eliminate Off-Balance Sheet Vehicles

Move all risky investments back on bank balance sheets and require adequate capital to support them. Capital requirements should be sufficient to protect bank solvency even during the liquidity crises that occur from time to time. As an illustration of the potential effectiveness of this proposal, consider that several years ago a group of Spanish banks approached the Spanish central bank asking permission to set up a network of SIVs that would allow them to profit from off-balance sheet holdings of mortgage-backed CDOs without setting aside capital to support them. The Spanish Central Bank demanded that these banks post an 8% capital charge against SIV assets, just as they would have to do if they were on the balance sheet. This stopped the innovation in its tracks (“Spain’s Banks Weather Crisis”, Financial Times, 31 January 2008). The Economist observed that “with no reason to set up the SIVs, the Spanish banks did not bother. Other countries could have saved themselves a lot of trouble by taking a similarly rigorous view of consolidation” (“Spanish Steps”, 17 May 2008). This sensible decision did not prevent Spain from enduring a housing-related financial crisis, but it did eliminate one key element of the meltdown in the US and elsewhere (“Time for Central Bankers to Take Spanish Lessons”, Financial Times, 30 September 2008). Spain, to be sure, did endure a huge real estate boom and crash. But it was the “old fashioned” kind, where banks lent developers and home buyers a great deal of money, creating a bubble. But, it was not fuelled by exotic derivatives, so, Spanish banks were not vulnerable in the way US banks were.

3.3 Implement a Financial Precautionary Principle

Once the financial regulatory structure is extended to all important financial institutions, as we propose in point 3, it would be possible to implement a regulatory precautionary principle with respect to new products and processes created by financial innovation similar in principle to the one used by the US Food and Drug Administration to determine whether new drugs should be allowed on the market. Destructive innovations were at the centre of crisis-creation. Spanish banks had to ask permission from the Bank of Spain to create off-balance sheet SIVs. This principle could be extended to all financial institutions and all important proposed financial innovations. Regulators would determine

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whether these innovations are likely to increase systemic fragility. Typically, the regulatory authority would do as the Spanish authorities did: tell the financial institution that as long as it can raise sufficient capital to insure that the risk to that institution is minimal, it can implement it. Regulators would be empowered to monitor the evolution of the innovation to make sure that it does not threaten systemic stability. However, there would be cases in which the regulatory authority would prohibit the innovation on the grounds that even with more capital, it would have serious negative externalities for the system. China’s system of regulation includes a strict policy of “anything not specifically permitted is prohibited”. When asked what other countries could learn from China’s regulatory system, Liao Min, director general and acting head of the general office of the China Banking Regulatory Commission (CBRC), replied that “Chinese financial institutions needed CBRC approval to launch individual product types, making it nearly impossible for exotic financial instruments, such as the ones blamed for the subprime crisis, to exist in China”. As a result of this practice, “Chinese banks have emerged relatively unscathed from the global credit crisis …” (“China Says West’s Lack of Market Oversight Led to the Subprime Crisis”, Financial Times, 28 May 2006). Until South Korea accelerated the liberalisation of its financial system in the mid-1990s, its government maintained a list of acceptable banking practices. Financial institutions had to get regulators’ permission to do anything not on the list. We suggest careful consideration of the “anything not specifically permitted is prohibited” principle, and briefly elaborate on this below.

To implement a financial precautionary principle, several economists have proposed instituting a Financial Products Safety Commission, to inspect financial products both before they are issued and to continue testing and monitoring those that have been allowed to enter the market (Stiglitz 2009; Soros 2008).

There are a number of objections that may be raised to such a reform. First, it may be objected that a Financial Products Safety Commission will unduly stifle innovation, leading to significant losses to the economy. Yet, while it certainly must be the case that some financial innovations are quite useful, there is, in fact, very little evidence of either a theoretical or empirical nature that financial innovations in general have a significant positive impact on economic growth or development (Elul 1995; Frame and White 2002). And there is a great deal of evidence and concern that many financial innovations are largely motivated by the desire to evade taxes, avoid financial regulations, and create temporary monopolies that allow firms to charge excessive fees (Tobin 1984; Van Horne 1985; Tufano 2003).

Second, it may be objected that the process of applying for permission to market a new product will be too complex and difficult to structure. But financial regulators at the Bank for International Settlements (BIS), regulatory agencies, and investment bankers themselves have come up with elaborate check lists that they believe banks should implement in deciding whether to market or use new financial products, including demonstrating to themselves that their upper level management and clients can understand the real risks associated with financial products. Of course, these organisations are committed to self-regulation, and insist

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the banks simply adopt these “best practices”. But a Financial Products Safety Commission could insist that the issuers of new financial products provide convincing evidence to the commission of what the risks are, that their management has the capacity to manage the risks, and that their clients do so as well. In other words, if the banks can self-regulate sufficiently, then they and their products can be regulated by external regulators as well.

Third, it may be argued that we cannot identify the characteristics of financial innovations that are dangerous. But the banks and investment banks that created these “innovations” know quite well what aspects have made them so dangerous (CRMPG, III 2008).

These include, first, a high degree of leverage especially if it is embedded in instruments in complex ways. Second, these instruments are prone to periods of sharply reduced market liquidity. Third, the instruments may be characterised by a lack of price transparency. Fourth, significant maturity mismatches that lead to significant liquidity risk in a downturn; and fifth, pure complexity that will challenge the management’s and customer’s ability to manage the risks (CRMPG, III 2008).

The CRMPG committee proposed that only sophisticated investors be allowed to trade these instruments. Of course, this implies that these risky instruments can be identified as such. Having identified them, the Financial Products Safety Commission can furthermore determine whether they are too risky to be traded even by sophisticated investors. Of course, given the interconnectedness of different institutions and markets, the safe course of action would be in most cases to prohibit such products from being traded in the first place.

Indeed, there is now agreement that if regulators do not adequately prevent risk, they have to “test” the risk of banks and others not by asking what would happen to them if something bad happened, but rather what would happen if something bad happened to everybody so that there is a systemic problem and consequent liquidity evaporation and counter-party failures. No one does this now.

Fourth, it may be argued that the process of product approval could get corrupted; lobbying by financial firms, for example, could lead to the approval of products that should not be approved. Of course, the corruption of the regulatory process is always a potential danger in any field. The key to avoid this corruption is to have highly skilled, highly paid regulators with high status; oversight groups made up of a group of knowledgeable stakeholders and experts, including potential financial instrument users, academics and policymakers.

4.1 Prohibit the Sale of Financial Securities That Are Too Complex To Be Sold on Exchanges

Eighty per cent of all derivative products and 100% of the complex CDOs, CDSs and other exotic financial instruments implicated in the current crisis are traded off markets or over-the-counter (OTC). If regulators insist that all derivative securities must be exchange traded, those OTC securities that can be simplified

BANKING AND FINANCE: REFORMING THE SYSTEM

and commodified will shift to exchanges where they will be transparent, involve less counter-party risk, and be cheaper sources of finance. “Simpler products impose lower costs of credit analysis on end users, which in turn makes them less expensive sources of funding” (“Ruptured Credit”, The Economist, 17 May 2008). The most complex products, including CDOs, cannot be sufficiently simplified and will disappear from the market (“Fed Plan Is Spoilt by Its Backing of Hypocrites”, Financial Times, 15 April 2008, for one such proposal). Of course, investment banks and hedge fund traders would not meekly accept such a proposal since writing and trading complex derivatives OTC is a source of huge profits (“Clearing the Fog”, The Economist, 19 April 2008). A general ban on OTC derivative trading has one key advantage over attempts to prohibit specific products such as CDOs. Investment banks can evade regulations banning specific products or services by creating alternative products that are not identical, but perform the same functions. Prohibiting OTC products would eliminate this form of regulatory evasion. NFA supporters would argue that this reform would inhibit useful innovation, but it is now clear that the societal costs of such innovation – in terms of financial crises that cause or exacerbate real sector problems and require government bailouts – far exceed their possible social benefits (“A New Formula”, Financial Times, 1 October 2008).

4.2 Require Due Diligence by Creators of Complex Structured Financial Products

Require the investment banks that create mortgage-backed securities, CDOs and other opaque mortgage-backed financial assets to perform “due diligence” on the individual securities embodied in these products. “Due diligence” would obligate the issuer to evaluate the risks of each underlying mortgage, then use this information to evaluate the risk of the asset-backed security under varying conditions that might affect the value of the underlying mortgages. This task would be difficult and costly if done properly; it could make the most complex securities unprofitable. If this cannot be done to regulators’ satisfaction, sale of these securities should be prohibited. A related requirement should be that the underlying mortgages in a complex security must be identifiable, and ultimate ownership of these mortgages must be clear. Where this is not the case, securities cannot be “unwound” in a crisis and the terms of the mortgage cannot easily be adjusted to stop the spread of defaults. Imposition of this requirement would probably close the market for CDOs and more complex securities based on CDOs.6 At present, investment banks claim to assure the safety of these assets through over-collateralisation. For example, investors can buy tranches of the expected cash flows from the mortgages in a CDO that will receive their payments before holders of riskier tranches do. Mathematical models are used to demonstrate the safety of such tranches under various adverse conditions, but these models have been shown to be totally unreliable under the threatening and uncertain conditions of the current crisis. A “due diligence” requirement would also reduce the deleterious role played by ratings agencies in the NFA.

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5.1 Restrict the Growth of Financial Assets through Counter-Cyclical Capital Requirements

A number of the previous suggestions might help restrict the excessive growth of financial assets in the boom. But they may not, by themselves, eliminate the excessive growth of financial assets. As a number of observers have noted, asset creation is extremely pro-cyclical (see, for example, Wray 2008). As asset prices rise, bank capital also rises, so banks can increase loans until they hit regulatory capital constraints. This lending leads to a rising demand for securities and thus higher security prices, which allows the process to continue. To assure control of the rate of expansion of financial assets, regulators should impose counter-cyclical capitalasset ratios (Adrian and Shin 2008). Spain experimented with such a policy. “Since 2002 the Bank of Spain has had something called a ‘dynamic provisioning’ regime, where bank provisions go up when lending is growing quickly... Over the cycle the effect is neutral, but the timing of provisioning should make the troughs less deep and the peaks less vertiginous” (“Spanish Steps”, The Economist, 17 May 2008). Though Spanish regulators did not impose this policy with sufficient vigour, its experience is suggestive.

5.2 Create a Bailout Fund Financed by Wall Street

When the Federal Deposit Insurance Corporation (FDIC) rescues failing commercial and savings banks, it uses insurance funds paid for by the banks themselves, not by the taxpayer. A similar insurance scheme should be created to finance bailouts for other kinds of financial institutions. The government should impose a small transactions tax on all security sales (see Pollin 2005 for a general discussion of the transaction tax). The tax rate might be calibrated to generate about $100 billion in annual tax revenue. The fund would typically accumulate hundreds of billions of dollars in normal and boom times prior to the outbreak of a financial downturn. If effective regulations are put in place that prevent a truly dangerous risk buildup in the expansion phase of the financial cycle, the fund should have more than enough money to rescue those institutions that fail in the downturn.