Thursday, June 18, 2009

The simplicity of financial regulation

With all the buzz on financial regulation and Obama's new proposal, people often miss the basics. Regulation of financial institutions (outside of securities and consumer protection regulation) should focus on two key items:

1. Capitalization. JPMorgan was involved in all the activities that Citi was. Securitization, mortgages, leveraged loans, investment banking, derivatives, etc. What put Citibank close to bankruptcy, while JPM got larger and potentially more profitable from the crisis (with Bear and WAMU acquisitions)? Citi was poorly capitalized relative to the massive risks they were taking.

2. Liquidity. Another critical issue that gets financial institutions into trouble is the inability to roll short-term liabilities that are used to finance illiquid longer term assets. Large entities holding long term illiquid bonds that are financed by commercial paper (short-term instrument) got Citi into huge trouble. Bonds financed via the overnight repo market got Bear into trouble. Examples of this are not limited to 07-08. Similar issues popped up in 98 and earlier. The inability to roll short term liabilities combined with difficulties liquidating the assets is a reoccurring theme. It's like buying a house with a one-year balloon mortgage. Corporate treasurers refer to this concept as Asset-Liability Management 101 – you must match your asset and liability profile.

The two issues above go hand in hand. If an institution is well capitalized, it can afford to take additional liquidity risk. If it matches assets and liabilities well (borrowing long-term to finance illiquid assets), it will not need as much capital.

One other regulatory item that is important to address has to do with derivatives. Institutions must maintain appropriate margin requirements on all derivatives transactions. If AIG was asked to put up margin (to institutions who bought protection) long before AIG got downgraded, the amount of CDS they had written would have been a fraction (if any) of the actual amount.

How does a regulator implement such requirements? A comprehensive set of stress tests that address deteriorating credit quality and/or market value of portfolios, inability to roll short-term debt, default of a major counterparty, etc. should do the trick. The stress tests would get adjusted periodically to pick up the latest trends. The rest is implementation and oversight to make sure institutions are applying the stress tests properly.

When it comes to regulation, conceptual simplicity is key. Creating thousands of complex rules and setting up layers of bureaucracy will only allow financial institutions to find another loophole. That’s what happened with the Basle Accord (see The holes of the BIS rule book.)

Unfortunately simplicity doesn’t get votes, and when you have an administration that runs a permanent campaign, populism sometimes becomes the mantra.
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