I’ve been reading the 21-page Policy Statement on Financial Market Developments of the Hank-Paulson-led President’s Working Group on Financial Markets. It’s got a lot of acronyms in it. It’s also five years late and a few trillion dollars short, but that’s almost always the case with financial regulation. We’re very good at designing rules to prevent the last big bad thing that happened from happening again. We’re not so good at preventing new bad things from happening.
Anyway, the diagnosis of what went wrong strikes me as largely correct. Here’s what the working group (which consists of folks from Treasury, the Fed, the SEC and the Commodity Futures Trading Commission) says were the “principal underlying causes” of our current troubles:
• a breakdown in underwriting standards for subprime mortgages;
• a significant erosion of market discipline by those involved in the securitization
process, including originators, underwriters, credit rating agencies, and global
investors, related in part to failures to provide or obtain adequate risk disclosures;
• flaws in credit rating agencies’ assessments of subprime residential mortgage-
backed securities (RMBS) and other complex structured credit products,
especially collateralized debt obligations (CDOs) that held RMBS and other asset-
backed securities (CDOs of ABS);
• risk management weaknesses at some large U.S. and European financial
institutions; and
• regulatory policies, including capital and disclosure requirements, that failed to
mitigate risk management weaknesses.
As for what to do to prevent this from happening in the future, the recommendations around mortgage lending have gotten the most press. For good reason: They’re by far the clearest and most forceful of the lot. Paulson & Co. are essentially calling for national mortgage regulations, with all lenders subject to the same licensing, underwriting and disclosure standards. Which wouldn’t solve all the world’s problems, but would make the kind of regulatory arbitrage that spurred the spectacular and ultimately disastrous rise of nonbank, nonthrift subprime mortgage lenders over the past few years much harder. So that’s something.
For the rest, though, the recommendations are all in the line of investors and banks and ratings agencies all need to be more careful, ok? Plus we need lots of studies on how to make regulations work better. I’m sure we do. But it would be nice to see at least hints of bolder ideas like:
1) Slashing regulatory reliance on ratings agencies (this is what my column this week is about; I’ll link when it goes up online). The report does say that “Regulators should review the current use of ratings in regulation and supervisory rules,” but doesn’t go much farther than that.
2) Doing more to shift our financial system away from illiquid, customized securities to commoditized, tradeable ones. Organized financial markets are amazing things. Sure they go crazy sometimes, and get prices wrong a lot of the time. But they’re really good at incorporating new information and changing their minds. The big problem right now is that the financial system is clogged with securities for which there are no markets, and no agreed-upon prices. Every couple of months, the uncertainty of it all threatens to shut down the whole process of financial intermediation–forcing the Fed and other central banks to more or less artificially set prices for this stuff by accepting it as collateral for loans. It seems to me that in the future, regulators ought to be pressure financial institutions to transact as much of their business as possible in transparent markets rather than in opaque over-the-counter deals. For example, what if they simply decreed that securities that aren’t traded regularly don’t count for nearly as much (in terms of capital requirements and such) as those that are–whatever rating Moody’s and S&P have slapped on the things. Wouldn’t that make sense?
3) Flogging. We need some kind of punitive action to scare the world’s bankers straight for a while. So why not public floggings of disgraced bank and securities firm CEOs? It’d be fun for the whole family! Unless you think being interrogated by Henry Waxman is already punishment enough.
Update: Felix Salmon has another bold idea that the Paulson report fails to mention: Doing something about the “alphabet soup” of financial regulation in the U.S., where you have lots of different, sometimes competing regulators and no one really in charge:
If the current system remains in place, does anybody seriously believe that “supervisors of global financial institutions” will be any better at monitoring “risk management weaknesses” than they have been up until now?