The Counterparty Risk Management Policy Group III, or CRMPG III, in the US has issued its report on how to strengthen the rules and institutions surrounding risky financial instruments to minimize systemic risks.
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Its name may be uninspiring, but the group is influential—it is backed by most Wall Street firms. Yet, two previous reports led to only mixed success carrying reforms through. The current financial crisis could mean these needed reforms have a better shot at implementation.
CRMPG III—co-led by Goldman Sachs and Co. managing director and former New York Federal Reserve president Gerald Corrigan and HSBC Holdings Plc.’s group finance director Douglas Flint—called for several sensible things.
Off-balance sheet vehicles should largely be brought on balance sheet. A standard procedure for closing out derivatives when a counterparty defaults should be put in place. Monitoring of counterparty risk needs to be more comprehensive and more quickly available. Highly risky, complex financial instruments should be sold only to genuinely sophisticated investors. And better stress tests should be put in place to measure possible liquidity outflows.
These efforts are largely built upon the recommendations of the first two CRMPG reports, the first of which followed the near-collapse of the Long Term Capital Management hedge fund in 1998. While those efforts led to progress in areas such as settling trades, other important areas didn’t advance much.
The fact that the US central bank felt it had to rescue Bear Stearns Companies Inc. because its derivative positions made the bank too complex to fail shows why Corrigan et al should have been heeded earlier.
The recent multibillion dollar write-downs on Wall Street should help ensure that this time, reforms are given a real chance rather than pushed under the rug.