Once we do enough fire-fighting to move the financial crisis from existential-threat status to just another hole we have to climb out of, the time will have arrived to redesign the developed world’s financial regulation framework. I’m not a pro, but I’ve been in business for some decades and I’m an investor and know quite a bit of accounting, and I have opinions.
Oh, and if any right-wing fundamentalists or Randroids want to explain how if government just gets out of the way the market will protect us, please first read this and then go away. Thank you.
Introduce Reasonable Judgment · Too much of the regulatory framework has historically been an effort to write rules that are so tight and detailed that the financial systems’ sharpies can’t find away around, through, or under them. It doesn’t seem to work very well. If I were redesigning the sucker, I’d dramatically slash the number and size of the rules and rely in almost every case on “reasonable judgment”.
In this, you get rules of the form “You can’t sell anyone an investment they can’t reasonably be expected to understand.” Or “You can’t develop any financial instrument whose purpose can reasonably be judged to move a liability off the balance sheet.” Or “Banks can’t let their capital ratios drop below a level that can reasonably be judged to be safe.”
Yeah, this would give the court system a perhaps-dangerous amount of power and leeway. I’m fine with that; it’s hard to believe that it could be any more dangerous than what we’ve seen in recent decades.
Ratings Agencies · There are a lot of culprits who share the blame for the current debacle, but there’s only one group which clearly could have stopped the whole thing in its tracks if operating as intended: The ratings agencies. The idea was that anything rated AAA should be safe enough to drop into a pension fund. It’s not that none of them will ever default, but that the proportion of failures will be small enough that if you diversify a bit, you’re confident of capital preservation.
Of course, what happened was that the rating agencies became dependent on credit issuers for their bread and butter, and the onset of corruption was 100% inevitable at that point. There was a time in history when debt buyers paid the ratings agencies; several of the postmortem analyses I’ve read explained the change-over with something along the lines of “The volume and complexity of credit instruments made this nonviable as a business model.”
BZZZZZZZZZZZZZZT! Wrong. What we ended up with was really nonviable. If you can’t afford to pay someone qualified to get an independent opinion, then you can’t afford to loan the money. Maybe a coherent case can be made that these puppies ought to be in the public sector. If you’re doing it to protect the interests of investors it can hardly be socialism, can it?
I’m not smart enough to prescribe the ideal solution. But anyone with half a brain can see that ratings agencies in the pay of debt issuers can’t possibly be part of it.
Share the Pain · This is an idea I got last month from Nick Carr’s piece No Worries. Specifically, he proposes modifying deposit insurance, essentially by adding a deductible like I have on my auto insurance. The idea is that you don’t want citizens’ deposits wiped out in a bank failure, but maybe it’s not a bad thing to impose a little pain on them in that circumstance, to make us all a little more paranoid and suspicious about bankers.
There’s an analogy here to the open-source dogma: “Given sufficiently many eyes, all bugs are shallow.” The idea is that if everybody involved in the system shares some part of the risk of failures, the general level of vigilance is thereby increased and with any luck some of the failures are averted.
The Balance Sheet is Sacred · I am quite skeptical of some of the core tenets of the accounting profession’s belief system; for example, the superstition that capital spending and operational spending dollars are magically different from each other. Having said that, the notion of the balance sheet seems to be sort of at the center of everything: Here’s what we have, here’s what people owe us, and here’s what we owe.
But time and again, when crisis strikes all sorts of liabilities crop up that were somehow magically absent from the balance sheet. In fact, the whole raison d’etre of postmodern financial instruments like the SIV was to move things off-balance-sheet. I, like everyone else even remotely connected to the finance industry, has seen presentations from time to time advertising the advantages of this kind of structured product.
At this point, the phrase “off-balance-sheet” makes my blood boil. If I were writing the next revision of the financial regulations, it would include something along the following lines: “Should a company enter into any contractual relationship which at some point in time imposes a liability on the company, and should it be established that this possibility was not accurately described in the company’s balance sheet, this is deemed evidence of criminal intent to defraud on the part of the company’s Directors and Officers.”
That might get their attention.