Alan Dukes: regulatory reform
Alan Dukes considers how recent evidence and admissions of errors in the financial markets can inform those designing new regulatory reforms.
Two hugely significant admissions have been made in the last few weeks or so: they must not be allowed to escape the notice of our financial regulators or of those currently engaged in designing regulatory reforms on both sides of the Atlantic.
The first admission was by John S. Reed,
who was one of the main movers behind the merger that led to the creation of
Citigroup Inc. He admitted recently that his support for the 1999 repeal of the
Glass-Steagall Act was misguided. That Act provided for the separation of
traditional customer-banking services from activities in capital markets. Its
repeal opened the way for the creation of huge and widely-diversified financial
conglomerates.
In theory, such diversification might have been expected to spread risk over a wide range of activities, thus reducing the effect of exposure to any specific category. What seems to have happened, however, was that risk assessment and management were equally bad across all categories, leading to the catastrophic collapses with which we are all too familiar.
Citigroup Inc. was the pioneer of collateralised debt obligations (CDOs). Huge volumes of CDOs were "manufactured", comprising frequently of bundles of slices of
subprime mortgages. Defaults on payments on these mortgages finally brought the whole structure tumbling down.
In 1998, Citicorp, then a commercial bank, merged with Travelers Group Inc., an investment firm, to form Citigroup. Reed was co-chairman and co-CEO of Citigroup from 1998 until his retirement in 2000. Between 1997 and 1999, he was paid $23.4m in salary and bonuses and received a retirement bonus of $5m in 2000. Being doubly an architect of disaster was thus rewarded to the tune of $28.4m in four years!
The second admission came from David Einhorn, who founded Greenlight Capital which has been described in the Financial Times as "one of the earliest and most prescient users of credit default swaps" (CDSs). These have turned out to be another of the most toxic instruments to infest financial markets.
They are, in effect, insurance against the default of a borrower but can be purchased by persons or entities with no insurable interest in the defaults. This is described as having no "skin in the game", a phrase which reminds me of a charming French phrase to describe something very expensive "ça te coûte la peau des fesses" - literally that costs you the skin off your buttocks", a painful condition now well-known to many financial-market operators!
Einhorn is now reportedly calling for CDSs to be banned. I agree. If any such instrument is to be envisaged, it should require the buyer to show an insurable interest in the contemplated event. In my view, this is clearly an area in which the boundary between insurance and finance must be redrawn.
These two admissions should be heeded by those contemplating the reform of financial market regulation. It seems to me that they add to the case for one of my propositions, supported by Willem Buiter during the Business and Finance International Financial Services Summit 2009 on November 5th. That proposition is that there should be an approved "positive list" of financial instruments and that the marketing of any new instrument should be subject to prior regulatory approval. We must at some point start learning from some of the most egregious errors of the past.
We can only wonder how many more admissions of this kind might be forthcoming before we have a new regulatory architecture. There is surely enough information emerging from the carnage in financial institutions to guide us. The Citigroup Inc. experience certainly strengthens the case for "narrowing" the structure of institutions, despite the smart manoeuvre which saved the skin of Goldman Sachs in the aftermath of the Lehman Brothers collapse.
Goldman Sachs is now one of the most able opponents of regulatory reform, now that it is back in profit and making enormous provision for the kind of bonuses that marked the over-exuberance of pre-crash financial institutions. They seem hell-bent on using history to teach us how to make the same mistakes again.
