Regulatory Reform and Risk Management: Will The Current Reform Help?
Regulatory reform is here. The Senate debate ended and a bill was approved last week. The debate now begins over whether the reform will bea good or bad thing. Of course, the question is good or bad for whom.
Do you really care whether the bill hurts financial firms or not? Do you really care whether some government agency or the Fed loses or gains power as a result of this bill? I know what I care about: will this reform help us in any way. Us means you and me, you know, personally.
Back on April 22nd, I wrote:
I read a quick summary in the Wall Street Journal of the proposed regulations - not the proposed regs themselves. But the source was pretty reliable and I don't have time to pour through the regs themselves.
The changes will be big. Wall Street firms will have to adjust their business models to accommodate. They will.
But let's get down to us. Will these regs help manage risk? In my previous post, I suggested that for new regulations to have a positive impact on risk, two areas they'd have to address were derivative trading and leverage.
Regarding derivative trading, it looks like most derivative trades will have to be placed through a clearing house. That means they will be somewhat more transparent (if anyone bothers to carefully monitor them, that is). In the past, many of what I considered dangerous derivative trades were done over-the-counter (OTC) and therefore out of the sight of anyone but the parties involved. Therefore they couldn't be effectively monitored. No one had any idea who was involved and how possible counter-party failure would ultimately affect the financial system. (Counter-party failure occurs when one party to a trade fails to fulfill its promise - either to buy or sell money or securities at some point in time, or based upon some event.)
So the monitoring of derivative trades placed through clearing houses - if the trades are accounted for and monitored - would seem to be a positive step in assuring a higher level of risk management than we now have. Therefore the financial system as a whole should be less at risk from derivative trading. But the monitoring is a pretty big and complicated venture, so I don't know if it will be effective or not.
As for the issue of leverage, I don't see anything specifically addressing that. There are increased requirements for banks of a certain size (over 250 billion in assets) to make sure those assets are of a higher quality than currently required. While I don't know what that standard is, I'm hoping it basically says they can't claim junk items like CDO's as an asset on their books anymore. (The value of CDO's and other junky assets like crappy subprime mortgages simply melted in value during 2007-2008, helping to cause the banking crisis.)
But I'd like to see some restriction on the leverage institutions can use overall. Investment banks like Lehman and Bear were leveraged as much as 40 or 50 to 1 during the last crisis. The leverage allowed the institutions to show huge profits and pay out humungous bonuses - until the institutions collapsed when their trades turned the other way. Leverage will make you a ton of money when a trade goes your way; you lose a ton of money when a trade goes against you. A modest amount of leverage is acceptable. 50 to 1 isn't. That sort of leverage shouldn't be allowed. So far, I'm not seeing anything that restricts leverage in a way I think it needs to be restricted.
And there's another problem that hasn't been discussed, but may be part of this regulatory reform. It was addressed by Cliff Asness and Aaron Brown in a 5/13/10 Wall Street Journal Opinion. As they read the proposed regs at the time, they saw the possiblity that the system would be set up so that large financial institutions would be the only ones that could participate in certain derivative transactions, under the proposed heightened scrutiny, public scrutiny, etc. That would give an advantage to those large institutions. Those large institutions, by the way, would be large banks.
Essentially, that means a kind of giant crony system where big government feeds and protects big banks in making money. Hmm, that sounds a bit like what we've been seeing all along, doesn't it?
In any case, regulatory reform is here, and we'll have to see how effective it is in promoting better risk management.
As for fundamentally changing the way Wall Street and the banking industry does business, it may well do that. But will all that wind up in any way benefiting you and me? At this point, I can't really tell.
Do you really care whether the bill hurts financial firms or not? Do you really care whether some government agency or the Fed loses or gains power as a result of this bill? I know what I care about: will this reform help us in any way. Us means you and me, you know, personally.
Back on April 22nd, I wrote:
If regulations just increase the power of government, what good is that?
On the other hand, if regulations help manage risk - to both individuals and the financial system - then maybe they make sense.
You can read the entire post by clicking here.On the other hand, if regulations help manage risk - to both individuals and the financial system - then maybe they make sense.
I read a quick summary in the Wall Street Journal of the proposed regulations - not the proposed regs themselves. But the source was pretty reliable and I don't have time to pour through the regs themselves.
The changes will be big. Wall Street firms will have to adjust their business models to accommodate. They will.
But let's get down to us. Will these regs help manage risk? In my previous post, I suggested that for new regulations to have a positive impact on risk, two areas they'd have to address were derivative trading and leverage.
Regarding derivative trading, it looks like most derivative trades will have to be placed through a clearing house. That means they will be somewhat more transparent (if anyone bothers to carefully monitor them, that is). In the past, many of what I considered dangerous derivative trades were done over-the-counter (OTC) and therefore out of the sight of anyone but the parties involved. Therefore they couldn't be effectively monitored. No one had any idea who was involved and how possible counter-party failure would ultimately affect the financial system. (Counter-party failure occurs when one party to a trade fails to fulfill its promise - either to buy or sell money or securities at some point in time, or based upon some event.)
So the monitoring of derivative trades placed through clearing houses - if the trades are accounted for and monitored - would seem to be a positive step in assuring a higher level of risk management than we now have. Therefore the financial system as a whole should be less at risk from derivative trading. But the monitoring is a pretty big and complicated venture, so I don't know if it will be effective or not.
As for the issue of leverage, I don't see anything specifically addressing that. There are increased requirements for banks of a certain size (over 250 billion in assets) to make sure those assets are of a higher quality than currently required. While I don't know what that standard is, I'm hoping it basically says they can't claim junk items like CDO's as an asset on their books anymore. (The value of CDO's and other junky assets like crappy subprime mortgages simply melted in value during 2007-2008, helping to cause the banking crisis.)
But I'd like to see some restriction on the leverage institutions can use overall. Investment banks like Lehman and Bear were leveraged as much as 40 or 50 to 1 during the last crisis. The leverage allowed the institutions to show huge profits and pay out humungous bonuses - until the institutions collapsed when their trades turned the other way. Leverage will make you a ton of money when a trade goes your way; you lose a ton of money when a trade goes against you. A modest amount of leverage is acceptable. 50 to 1 isn't. That sort of leverage shouldn't be allowed. So far, I'm not seeing anything that restricts leverage in a way I think it needs to be restricted.
And there's another problem that hasn't been discussed, but may be part of this regulatory reform. It was addressed by Cliff Asness and Aaron Brown in a 5/13/10 Wall Street Journal Opinion. As they read the proposed regs at the time, they saw the possiblity that the system would be set up so that large financial institutions would be the only ones that could participate in certain derivative transactions, under the proposed heightened scrutiny, public scrutiny, etc. That would give an advantage to those large institutions. Those large institutions, by the way, would be large banks.
Essentially, that means a kind of giant crony system where big government feeds and protects big banks in making money. Hmm, that sounds a bit like what we've been seeing all along, doesn't it?
In any case, regulatory reform is here, and we'll have to see how effective it is in promoting better risk management.
As for fundamentally changing the way Wall Street and the banking industry does business, it may well do that. But will all that wind up in any way benefiting you and me? At this point, I can't really tell.
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