The Bear Stearns bailout by the US Federal Reserve is raising concerns about how far regulators should go in their attempt to limit the damage of the subprime crisis. Former Fed chairman Paul Volcker and Federal Reserve Bank of Richmond president Jeffrey Lacker have criticized the Fed’s action in providing the liquidity window to the investment banks. The concern is that such actions only encourage market players to keep taking higher risk. They know there will be a safety net, given the government’s desire to avoid the systemic risk ripple effects that would cause widespread harm should the financial institution go into bankruptcy.
Until the 1980s, most global investment banks were private partnerships. The UK big bang began the dismantling of the barriers between investment and commercial banking, and most brokerages/investment banks in the UK were acquired by major commercial banks, including Citibank, Barclays and HSBC. The US followed with the listing of former partnerships such as Salomon Smith Barney, Shearsons and Goldman Sachs. The remaining bricks were removed (alongside the repeal of limiting provisions of the Glass-Steagall Act) with the merger between Citicorp and Salomon (through Travelers Insurance). Earlier, commercial banks’ losses were predominantly credit-related but, as we are seeing now, that has changed and the majority of the losses are from complex structures put together by the investment banking arms of commercial banks.
Three major factors appear to lead to the current problems.
The first is the amount of leverage that investment banks can employ. Unlike commercial banks — which are governed by Basel II and domestic regulations on the amount of tier I and tier II capital required, and which limits the leverage allowed — not accepting public deposits has given investment banks the leeway to employ as much leverage as they can raise in the market. Regulators need to set a limit to this, especially if they allow them a lifeboat from public funds.
The second factor is the use of derivatives. With derivatives now written on all financial products — whether foreign exchange, interest rates, equity, credit, commodities, or in exotic areas such as weather derivatives — the spider web of counter-party exposure puts the whole system at risk every time a major institution runs into a problem. Two decades ago, when a financial institution got into trouble, it was depositors and, subsequently, the interbank lenders who were the most concerned. The situation is now very different. There are layers of intertwined risk and, hence, the failure of even a mid-sized institution creates cracks in the entire financial system. Is there need for a derivatives clearing exchange?
The third issue is the valuation of some derivatives. Since they tend to be very complex and based on proprietary computer models, even experts find it very difficult to understand them. As we have recently seen in several cases, the valuation of these derivative positions is left to traders. Human nature being what it is, there will always be rogue traders who will, either out of greed or panic on their loss-making positions, take advantage.
Compensation is generally regarded as one reason for the problems. But, I feel it is a relatively small factor. Increasingly, a greater portion of the compensation is in the form of deferred stock to ensure that the players have “skin in the game”. In the case of Bear Stearns, the employees who owned almost one-third of the equity paid dearly right down to the junior level. The problem is, of course, the golden parachutes for the very senior people. This is where the board of directors has to take a proactive role. In a lot of cases, compensation is linked to the increase in the stock price—so, when values are destroyed, there should be no pay-out at the time of departure of the individual. In the fund management industry, apart from your management fees, your payout depends on your performance. Should that not be the case for all financial institutions?
Closer home, the Reserve Bank of India (RBI) is struggling with the issue of credit derivatives.
In the longer run, it will have to think about developing the securitization market, and whether it should encourage the entry of monoline insurers who tend to provide a layer of guarantee to complex structures and, increasingly, to derivatives as well. One way is to ensure that the guarantee providers are, in turn, owned by the market players.
As the economy develops, financial markets have to keep up with the needs of Indian companies, which are becoming increasingly global and will demand sophisticated financial options. RBI has to draw a fine balance between letting the markets develop and, at the same time, regulating them. It should increasingly allow monitored self regulation by the players by involving them in the entire decision-making process and encourage the sophisticated players, including the auditors, to share the best practices with the market.
RBI should walk softly but carry a big stick and punish the offenders, including the board of directors, severely.
Avinder S. Bindra is CEO of ARX Analytics and Advisory. Comments are welcome at email@example.com