Friday, May 9, 2008

Martin Wolf on financial regulation

I am somewhat late to this piece, though it took me a little while to condense it in my mind. There is a great article by Martin Wolf on a quote from Volcker.

Simply stated, the bright new financial system – for all its talented participants, for all its rich rewards – has failed the test of the market place.” Paul Volcker, April 8 2008

Then Martin Wolf, churns out 7 principles of regulation he calls the 7 C's that need to be kept in mind these are

  1. Coverage. Avoiding too much leverage in the system by off balance sheet that are designed to bypass regulation.
  2. Cushions. Equity capital and subordinated debt provide shock absorbers over the long run. Liquidity can provide longer time lines even when solvency is an issue and equity has been TEMPORARILY wiped out (insert mark to market whining here)
  3. Commitment. Originate and distribute is evil as there is no accountability as to the quality of the debt.
  4. Cyclicality. The existing rules create non-linear behavior by way of feedback.
  5. Clarity. Opacity in the OTC markets is partly to blame for the lack of good pricing.
  6. Complexity. Source of lack of clarity and lack of pricing models.
  7. Compensation. Wall Street is incentive to bet your money on risky schemes for immediate payout and when it blows up, well YOU blow up, not them. This a-symetric incentive is to be blamed for many of the current excesses.

After thinking it seems to me that the common thread of all this is risk management and risk pricing all linking to monetary level and debt levels.

  1. Coverage. Coverage is related to debt levels. Glass Steagal needed to be updated more than it needed to be repudiated. If 10x leverage on 1 of coverage wasn't enough for optimal financials, 30x in the shadow system proved disastrous. Asking for appropriate coverage is equivalent to asking for appropriate leverage. I have already blogged about establishing those limitation at the iBank and cBank in general. The cBanks created all their shenanigans to bypass the 10x. The iBanks lended way above safety levels.
  2. Cushions. Shock absorbers again related to debt levels. I have blogged in the past about the L3 asset problems and who was to hold them. The point is that holding onto illiquid hard to price L3 assets IS A VALUABLE SERVICE, borrow short, lend long. Whether it is VIABLE is a function of riding out the noise in the mark to market. An L3 asset holder should be limited in the amounts he can hold relative to equity but really LIQUIDITY is another way to ride that out, as is being done right now with the FED liquidity swap discount windows. Capital and the issue of solvency related to L3 assets forgets that these assets are supposed to be long term and temporary insolvency shouldn't trigger catastrophic events.
  3. Commitment. Legislating commitment is an interesting concept that essentially goes back to forbidding securitization on the surface of it. I would have liked a more in-depth analysis from Martin Wolf. Truth is that securitization in and on itself isn't evil. What is evil is a system that has an incentive to NOT PRICE CORRECTLY the debt. Again debt is good as long as the default risk is correctly priced in. Having the originators keep some skin in the game may not be a bad idea as they would have to price the risk CORRECTLY and be a lot closer to the ground in order to do that. That accountability, in both senses of the word, has been long gone in the current systems.
  4. Cyclability. Cycles may be the result of natural bi-stable models, which arise systemically in constrained feedback loops. More on that in the context of cell biology soon. In other words, wanting to avoid cyclability may be a naive goal that is just not achievable in largely unregulated markets. Debt levels of expansion and contraction may be a natural thing as we probe the limits of leverage. Legislation should focus on that level of leverage at the i/c/Banks and let the natural cycles hold. Removing them would kill the golden goose as they are a natural part. I have argued in the past that non-linear cycles may not be a bad thing as they amplify the moves and shorten the time of adaptation, the Japan style intervention only led to prolonged pain in the system.
  5. Clarity. This is the exchange idea for OTC products in derivatives. Adding to the public information around these derivatives really increases the pricing precision. All of this really says that we will better PRICE RISK, which in turn could enable us to increase leverage. Correctly pricing risk is at the core of the problem. Clarity goes a long way as it increases information and price discovery about these products. That one (the exchange for OTC products) is a no brainer.
  6. Complexity. Related to the previous one in the sense that pricing is key and complexity makes pricing more opaque. Complexity in and on itself isn't bad, take securitization which in and on itself isn't bad, but if a slice of the product is badly priced you have increased the number of products that are bad: it is a case of one bad apple can make the whole basket bad. Limiting leverage and monetary mass will limit the amounts of risk being explored and diminish the probability that you misprice the edges of risk and contaminate the basket. Again correct management of risk and pricing of risk doesn't mean we need to throw away complexity. Rather we can manage the risk associated with this complexity by limiting monetary mass.
  7. Compensation. This one is also a no-brainer. The financial industry has an incentive to take GREAT short term risk with leverage to juice YEARLY BONUSES because when the game is up, it is the investors money that evaporates but not LAST year bonuses. Clearly a compensation like the VC private equity approach where compensation is done at liquidation of the fund instead of yearly is a much fairer approach. Here again risk is at the center as the incentives are gamed AGAINST the investor, by taking more risk than the reward is, it is a case of mispricing of fees in relation to risk. Legislation could look at banning yearly payouts in iBanks and impose more of a VC like LP structure although I suspect that iBanks that take that approach and tie their compensation to the payout of the LP will be very succesful.


Juha Lindfors said...

I almost stopped reading at first C, where Wolf calls for complete coverage. Reminds me of people dreaming of 100% test coverage -- doesn't take a rocket scientist to figure it's not possible.

Marcf said...

Yeah, however calling for limitation of the levarage in the suppliers of leverage for the hedge and private equity is a simpler way to control most of it.