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Paulson scores low on financial reforms

Paulson scores low on financial reforms
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First Published: Fri, Mar 14 2008. 12 14 AM IST
Updated: Fri, Mar 14 2008. 12 14 AM IST
Hank Paulson’s plans to avoid a repeat of the current global financial crisis are only so-so. The full details of what the US treasury secretary proposes will be out later in the day.
But, on the basis of an extensive preview in T he Wall Street Journal (WSJ has an exclusive content partnership in India with Mint), Paulson only seems to have partially grasped the nettle on the key issues: monetary policy, incentive structures, bank capital, ratings agencies and risk management. Marks out of 10? About 4.
Look at the key issues in turn. First, monetary policy. A big cause of the bubble that preceded the bust was easy money. That, in turn, was largely because the Federal Reserve under Alan Greenspan ignored asset price inflation. Paulson apparently hasn’t even addressed this issue.
Second, incentive structures. A big cause of the excessive risk-taking on Wall Street was that bankers and brokers had one-way bets. They hit pay dirt when their bets with other people’s money pay off, but don’t share fully in the pain when they don’t. Again, Paulson seemingly has nothing to say on the topic.
Third, bank capital. The financial system is so fragile because banks have inadequate capital compared with the risks they are running—and because everybody has been relying too much on short-term borrowing rather than long-term funding. Paulson does recognize this is a problem and says the global rules that govern bank capital—so-called Basel II—need to be revisited. He also says liquidity standards will need to be refined. This is good. But until one sees concrete proposals, it’s not clear whether he is going far enough.
Paulson is also calling on US financial institutions—not just banks, but also the likes of Fannie Mae and Freddie Mac —to raise more capital and revisit their “dividend policies” to preserve capital. That’s absolutely the right message. Without more capital, the crunch could deepen dragging down the real economy. The snag is that the authorities will probably need to speak louder. Citigroup Inc. is still paying a dividend despite its massive losses; and Freddie said only on Wednesday that it didn’t have any dilutive capital raising plan.
Fourth, ratings agencies. Paulson rightly recognizes that investors have become over-reliant on the ratings produced by the likes of Moody’s, and Standard and Poor’s. The radical solution is to deregulate the industry by removing the official recognition of agencies, currently embedded in Basel II and US regulations. Paulson looks like he may be moving in the right direction. But it isn’t clear if he is prepared to go the whole hog.
Fifth, risk management. Again, Paulson recognizes there is a problem. He says that financial instruments are so complex that even sophisticated people can’t understand them. He also wants regulators to pay more attention to risk management policies in banks—in part by revisiting how risk exposures are accounted for. There may be the germ of a good idea here. But as yet it isn’t clear whether this amounts to much more than motherhood and apple pie.
So, Paulson has made a start.
But if he—and other politicians and regulators around the world—really want to minimize the chances of a repeat crash, they’ll have to do better.
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First Published: Fri, Mar 14 2008. 12 14 AM IST