Fixing the Financial System

January 15, 2009 2:34 PM

“There has been a failure of risk management to a point that is mind boggling."Obama advisor Paul Volker and the Group of 30 have issued a deceptively simple framework for fixing our financial problems.
posted by up in the old hotel (29 comments total)

Last link takes you to a 281k PDF.
posted by cjorgensen at 2:46 PM on January 15

campaignmemoriesfilter: Remember the last debate with McCain when Obama trotted out Volcker as one of Non-Frightening White Men that he associates with?

Let's see how that turns out for him.
posted by Joe Beese at 2:59 PM on January 15

There's something about people who do deceptive things that I find somewhat suspicious.
posted by The World Famous at 3:02 PM on January 15

What makes it "deceptively" simple? If you want to argue that the plan is over-simplified, go ahead and make the argument.
posted by The Tensor at 3:11 PM on January 15

Yeah poster. I agree with Tensor. What's with the "deceptively"??

I'm about to give it a good read through, but nothing struck me as deceptive in the first two pages.

I don't think anyone looks at economics as "simple." Trying to deal with macroeconomics on the whole is like trying to change the weather.

From a political action prospective, however, YOU HAVE to stick to a deliberate, focused, yet flexible plan with specific broad goals. Again, that's what you HAVE to do. So what heck is is with the "deceptively simple" comment?
posted by Lacking Subtlety at 3:20 PM on January 15 [1 favorite]

Risk management assumes that there are consequences you wish to avoid. If you're in a position where you just plain don't care what happens there really are no risks. I like to think of it as Government of We Don't Give A Fuck. It sure makes risk management easy.
posted by tommasz at 3:25 PM on January 15 [1 favorite]

Admins, could you please flag the final link with the OMG-OPENS-PDF int'l sign? "[PDF]"
posted by zpousman at 3:35 PM on January 15

What makes it "deceptively" simple?

If I had to guess, without having read the article, I'd imagine that he meant that the aforementioned framework for solving our financial problems appears simple enough when you're reading the article, but that it will in the long run prove to be rather more complex to implement.

you know: deceptively simple.
posted by shmegegge at 3:41 PM on January 15

Not to start a debate about semantics, but I always have read and used "deceptively simple" to mean "simpler than it appears". At a glance, the PDF's proposed solution seems complex; perhaps it is not so much.
posted by Earl the Polliwog at 4:13 PM on January 15

"Deceptively" doesn't have any agreed-upon meaning anyway. Hooray for derails.
posted by Navelgazer at 4:14 PM on January 15 [2 favorites]

Earl/Navel.

haha. noted.
posted by Lacking Subtlety at 4:30 PM on January 15

The article basically encourages regulatory reform and further oversight. Half of the article just gives credit to people. We've clearly learned nothing from SarbOx.

You can't perfectly oversee or regulate anything and the evidence points towards strongly imperfect oversight and regulation.

Don't listen to Paul Volcker. Just don't give anyone you're money unless you know exactly what they're investing it in, what they're investing in, how they've done in the past. If you lost money and someone's not telling you you're stupid, then they just want more money from you.

Sorry, I've been drinking and have other reasons for being angry.
posted by christhelongtimelurker at 4:39 PM on January 15

Summarizing that post, I think most very small scale savers and investors are blissfully unaware. How can retail banks stay in business offering their customers slaps in the face like below inflation rate CDs? Suckers. Sadly, more people are suckers than not and many people who aren't naive don't have a better option if they want to deposit their money rather than live hand to mouth with some kind of debt. Soooo angry!
posted by christhelongtimelurker at 4:44 PM on January 15

Metafilter: I've been drinking and have other reasons for being angry.
posted by pompomtom at 4:45 PM on January 15 [16 favorites]

Well it certainly is simple, and perhaps deceptively so if it purports to solve all the present problems in one go.

Let's see - it clocks in at 29 pages total, but pages 1 to 9 are overhead, as are pages 20 to 29, so in the remaining document we've got some 3,100 words of advise. So are our present problems that simple or is this a very, very sharp group of people?

Don't get me wrong; itt is interesting reading and I surely do appreciate the FPP as I might not have seen it otherwise, but I'm not sure if they've really addressed the underlying problem as I'd view it.

Risk Management wasn't so much the problem, rather it seems as though this one was caused by a combination of failure, at multiple levels. No simple explanation for this problem, I'm afraid; plenty of guilt to go around. There were clearly limitations and failures at every level of the chain, failures which were magnified as we moved up levels from origination to securitisation (to focus, for example, solely on real estate which wasn't the only bubble / problem we had), with the attendant increases in nominal value, leverage and risk / reward ratios.

Compounding the problem, many market participants wrongly assumed that fund would be available when needed, brining to mind David Swensen's quote

"Liquidity is overrated. Its only there when you don’t need it."

('Contrary-wise', May, 2000, The Economist).

We all know (now) what happened to many participants when liquidity disappeared from the credit markets; solid, well performing assets priced close to par (i.e., $1) were suddenly marked to market at $0.50, or in some cases much, much less, leading to balance sheet weakness if not meltdown and a desperate need of capital (David Swensen runs Yale's endowment money).

One thing that I noticed at the outset of reading this document; it seemed rather theoretical, in spite on the non academic grounding / reputation of Volcker, et al. It starts with

"Recommendation 1:

a. In all countries, the activities of government-insured deposit-taking institutions should be subject to prudential regulation and supervision by a single regulator"

Problem? ALL COUNTRIES?. Are we talking G7, G20, or the entire developed world? What about off shore money centres? This point alone seems very academic.

Another issue throughout was the lack of recognition that today the capital markets, and many participants, are global. This point

"Recommendation 4:

a. Managers of private pools of capital that employ substantial borrowed funds should be required to register with an appropriate national prudential regulator."

Ok, but what if I'm running client money and I park in Grand Cayman? Too close to The United States?

Hey not a problem, Vanuatu is the place for hot money now, and they ain't gonna ask me no questions nor regulate me either.

So exactly who is going to regulate my capital if I put in into a domicile that can choose between offering a safe home for my money or doing pretty much nothing else except fish to make a subsistence living?

Real world discussion of regulation seems lacking in this document on lots of levels, not just this.

The entire discussion of Government-Sponsored Enterprises (GSEs) (Recommendation 5) reiterates this is a very, very US centric document, not a surprise looking at the authors but see previous comments re: global financial system.


Curious that at the same time this document advocates that the United States carve out an official role for Government-Sponsored Enterprises the EU Competition Commissioner is (was, considering the credit crunch?) leaning pretty hard on state sponsored entities i.e., Germany's Landesbank, especially complaining about their implied government guarantees and lower cost of capital thereof. Gosh, more proof that America and Europe seem to be moving ever closer together on financial matters e.g., state guarantees, bailouts, etc.

It seems from reading the pdf that The United States is willing to accept some degree of government backing / guarantee in housing, but not other financial services.

"Recommendation 6:

a. Countries should reevaluate their regulatory structures with a view to eliminating unnecessary overlaps and gaps in coverage and complexity, removing the potential for regulatory arbitrage,"

Well, Regulatory Arbitrage is something The United States can blame themselves for to no small extent; for example, when Europe moved to Basel II US regulators only compelled the "largest and most international" American banks to migrate to this regulatory accord (Source: Federal Reserve Board, Basel II Capital Accord, Notice of Proposed Rulemaking, September, 2006).

In the short run this meant US banks were required to hold, in some cases, much less capital on their balance sheets than they might otherwise have to. And for banks, capital is the stock in trade. Less capital held on balance sheet means more capital that can be lent out, and more profit that can be generated. Of course less capital held by banks means under some circumstances (perhaps the last year?) much, much weaker banks. Banks who might need a bailout.

And another view is that this decision by The Fed had the unexpected side effect of creating a two tier regulatory system in an already heavily fragmented American banking market, with some banks operating under the Basel II accord, with other banks using a bastardised version (known in some circles as Basel 1.5).

Net / net - regulators didn't have a single, consistent view, two different systems might be applied, and all for no good reason. Although many suspected not invented here as the most acceptable explanation to American reluctance to embrace Basel II.

Under Regulatory Standards for Governance and Risk Management
Recommendation 9:, lots of good stuff, but this one

"f. Ensuring that all large firms have the capacity to continuously monitor, within a matter of hours, their largest counterparty credit exposures on an enterprisewide basis and to make that information available, as appropriate, to its senior management, its board, and its prudential regulator and central bank;"

is curious. The way modern banks operate you've got trades and positions of the most innovative, newest instruments almost always captured on Excel spreadsheets out on a trading floor somewhere. Enterprise wide risk management is something that all firms try to do but most don't do too well. And doing in in hours? Well, for many Risk Managers operating at the board level this is indeed nirvana.

Of course the vendors are going to be pushing this recommendation, hard, but I'm not sure is this viable at present. Needed, but viability is a different topic.


This advise about dynamic capital - "Regulatory Capital Standards Recommendation 10: " specifically

b. These benchmarks should be expressed as a broad range within which should be managed, with the expectation that, as part of supervisory guidance, will operate at the upper end of such a range in periods when markets and tendencies for underestimating and underpricing risk are great.

are very good; basically they're advocating allowing regulators to judge when firms should set aside more or less capital to support positions held on balance sheet.

But as a practitioner I wonder how this will work out in practice, however. Regulators need teeth, otherwise nobody will pay much mind to their concerns.


Fair Value Accounting Recommendation 12:; lots of good stuff here.

"b. The tension between the business purpose served by regulated financial institutions that intermediate credit and liquidity risk and the interests of investors and creditors should be resolved by development of principles-based standards...

YES. Bold is my own, but principles based standards allow regulators to decide based upon the SPIRIT not the LETTER of the law. No loopholes in a principles based regime. Very good.


The Oversight of Credit Default Swaps (CDS) and Over-the-Counter (OTC) Markets

I have to say, this was sorta toothless. On page ten they introduced the concept of "Large, systemically important banking institutions" and that's great. But surely these same institutions - no doubt, too big to fail - shouldn't be allowed to hold either CDS' or various, credit derived OTC instruments?

That seems the fundamental lesson we've learned this time around.

Interesting read. My first pass, I'll go through it a few more times.

Thanks for posting!!
posted by Mutant at 4:50 PM on January 15 [24 favorites]

Hey, can anyone help me clean up this mess on the floor? I believe its gobbets of my brain matter.
posted by jamstigator at 4:57 PM on January 15

Thanks, Mutant. Much appreciated as always.
posted by Ryvar at 5:22 PM on January 15

Economists like to make things complicated because it's the only way they can justify their field. There's an old joke about an economist actually observing the real world then uttering, "okay, that's great and all, but how would it work in theory?. Hang out with enough economists and you'll understand.

The reality is that to fix this whole mess is deceptively simple - but painful. It's the pain that the government is trying to avoid because, as is always the case, it's government's job to keep itself employed. Nobody gets elected for telling the truth, but the reality is what it is: we're in a debt overhang. The only way to clear a debt overhang is to bring those debts out to the surface and deal with them, either through bankruptcy or defaulting upon those debts if the burden is too great.

Bernanke and Geitner are too busy fighting the last war in their own little theoretical world and Paulson is too busy fighting to keep his buddies happy to realize how damned simple the solution is. Enforce the laws we have, expose the total debt outstanding, guarantee bank deposits, close the failed banks, charter new ones and be done with it ferchristsake. Propping up failed institutions gives you the zombies we see today - coming back for more and more and more, never satiated.
posted by tgrundke at 5:49 PM on January 15 [1 favorite]

Mutant, you're welcome. Thanks for reading. Your breadth of knowledge really elevates every discussion you post on.

As much as I respect you, I disagree with you on one point. Risk management, the failure to properly manage for the global risks in the financial system, was precisely the problem.

Where were the risk officers at Lehman Brothers, AIG, and Bear Sterns? Why weren't they concerned about the amount of leverage and risk in those institutions and the rest of the system? Maybe they were sounding alarms but no one wanted to listen because the profits spoke much louder than concerns about what might happen.

I think one consequence of the crisis is that risk management will rise to an executive level position in financial institutions. It's already happening.

As for the deceptively simple, well, I didn't give it quite as much thought as you all have. But suggestions in the report like taking away proprietary trading from investment banks and requiring hedge funds that use leverage (i.e. all of them) to register with a regulator and disclose their positions to the public seem simple, but are going to be very tough to implement.

Still, it's an interesting document because it could foreshadow where Obama might be headed.
posted by up in the old hotel at 5:53 PM on January 15

Credit Default Swaps need to be fucking outlawed, and their inventors should be imprisoned. That'd be a fair start.

All this making of paper assets out of thin air, or worse, liabilities, needs to be swept from the table with a Jack-Nicholson-like fury.
posted by Devils Rancher at 6:02 PM on January 15 [1 favorite]

"If an institution is deemed too big to fail, then it is only a matter of time before it finds a way to get big and fail." --samwick's law

"If they are too big to fail, make them smaller." --nixon's treasury secretary george shultz on fannie and freddie

Fixing the crisis: Two systemic problems
This column explains how lack of regulation and failed monetary policy caused the failure of financial markets and then illustrates the banking crisis with simple arithmetic. It concludes that the automatic adjustment of free markets is ineffective in producing a recovery from this recession.

also see:
-The Crisis and the Policy Response
-Banks’ Loan Losses Could Reach $2 Trillion
-Nationalize Citigroup and Bank of America

Fixing the financial system
Following the analysis of the crisis’s causes in the yesterday’s column, this column suggests that the new financial regulatory system should impose effective reserve requirements on deposit-taking banks, and impose capital requirements for virtually all financial institutions with these requirements being counter-cyclical to dampen the boom-bust cycle.

also see:
-Stabilization Oversight Council (SOC) or Bust
-Some Thoughts on 2009
-Wall Street, Circa 2010: Disaggregation and Specialization

The myth of the riskometer
Much of today’s financial regulation assumes that risk can be accurately measured – that financial engineers, like civil engineers, can design safe products with sophisticated maths informed by historical estimates. But, as the crisis has shown, the laws of finance react to financial engineers’ creations, rendering risk calculations invalid. Regulators should rely on simpler methods.

What I Would Do
If I were offered the opportunity to fix things, I would take it, and:

• Create a new RTC for the small stuff
• Create a new chapter in the bankruptcy code for Too Big To Fail institutions
• Create a means of resolving home foreclosure issues in a manner similar to Chapter 11, which would lead to more compromises.
• Institute true tax reform that eliminates the sheltering of income, and eliminates all tax preferences.
• Wind down the Fed’s current “solutions”
• Begin inflating the currency to force up the value of collateral relative to nominal debt levels

The last one I like the least, but I’m afraid it would have to be done. Phase two would be:

• Move to a currency that is gold-backed.
• Replace the Fed with a currency board.
• Create a new unified regulator of all depositary institutions.
• Slowly raise bank capital requirements, and make them countercyclical.
• Bring all agreements onto the balance sheet with full disclosure.
• Enforce a strict separation between regulated and non-regulated financials. No cross-ownership, no cross-lending, no derivative agreements between them.
• Bar investment banks from being publicly traded, and if regulated, with strict leverage/risk-based capital limits.
• Move back to balanced budgets, and prepare for the pensions/entitlements crisis.

just a few straightforward and sensible suggestions (altho i don't necessarily agree with a return to a gold standard per se, or currency devaluation for that matter ;) i've come across recently; obviously a lot more has been and will be written!
posted by kliuless at 6:13 PM on January 15 [2 favorites]

Recommendation 5:
a. For the United States, the policy resolution of the appropriate role of GSEs in mortgage finance should be based on a clear separation of the functions of private sector mortgage finance risk intermediation from government sector guarantees or insurance of mortgage credit risk.
b. Governmental entities providing support for the mortgage market by means of market purchases should have explicit statutory backing and financial support. Hybrids of private ownership with government sponsorship should be avoided. In time, existing GSE mortgage purchasing and portfolio activities should be spun off to private sector entities, with the government, if it desires, maintaining a capacity to intervene in the market through a wholly owned public institution.

Yes, indeed...
posted by ZenMasterThis at 6:32 PM on January 15

So are our present problems that simple or is this a very, very sharp group of people?

I'll choose b, a a very, very sharp group of people. It's interesting that the incoming Treasury Secretary is still listed as a member, along with the left's very own blogging nobel laureate, Paul Krugman.
posted by alms at 7:54 PM on January 15

I feel dumber and marginally more entitled for having read everyon's responses. Metafilter is basically smart. I mean, you reveal links that I find interesting that I may not have come across otherwise. And the insight is usually pretty good too. I gues I reckoned on more insight...
posted by christhelongtimelurker at 10:00 PM on January 15

I think one consequence of the crisis is that risk management will rise to an executive level position in financial institutions. It's already happening.

The whole concept of an internal risk manager stinks. The risk manager is going to be ignored when money is being made from dangerous deals, and listened to when money is being lost. This is why external risk assessment from disinterested parties is needed - to enforce best practices at precisely the time when they are least wanted.
posted by benzenedream at 11:48 PM on January 15

I feel dumber and marginally more entitled for having read everyon's responses.

The drunk guy feels dumber.
posted by dirigibleman at 1:10 AM on January 16

Deceitfully simple solution:

1. Don't allow corporations to become to big to fail.
2. Allow corporations to fail.
posted by dances_with_sneetches at 5:26 AM on January 16

Vanuatu is the place for hot money now...

The returns on those Cargo Cult (LLP) synthetic CDOs are looking pretty attractive these days...
posted by malocchio at 8:51 AM on January 16

There is a lot of bureaucratic talk in there, but I think it ultimately boils down to more transparency.
Factors that have sunk the edge players taking on too much risk, and even those very mainstream (even establishment) groups shared a lack of transparency.
When a CDS can result in a string of transactions as each successive party hedges their risk until an ultimate (potentially under-capitalised) hedge fund holds the default risk, with no oversight, we have a situation where transparency is inadequate.
When my local government loses some millions in sub-prime related investments rated too highly by a bunch of for profit ratings agencies, we have a lack of transparency.
When the Fed is accepting undisclosed asset classes for loans we have a massive lack of transparency.
I think the only argument against increased transparency and increased regulation is that it may cramp the style of operators at the margins, and too many in the government are still beholden to those voices.
posted by bystander at 5:08 AM on January 18