Shyamsunder Panchavati

Shyamsunder Panchavati
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Tuesday, January 26, 2010

Obama's Bank Reforms Could Be Better — Here's How

Obama's Bank Reforms Could Be Better — Here's How

by David Champion

In a post yesterday, I pointed out that the Obama bank reforms aren't exactly the second coming of Glass-Steagall — and, more importantly, that they wouldn't have stopped the 2008 credit crisis. How could Obama build a better package of financial reforms? There are certainly some interesting ideas around that the Administration could take a closer look at.

In a blog about the Financial Crisis Inquiry Commission last week I described a proposal by MIT's Andrew Lo that the government create a forensic agency dedicated to investigating major financial "accidents" — a Capital Markets Safety Board comparable to the National Transportation safety board that investigates air disasters — whose work would greatly inform oversight of the financial markets and reduce the chances of future financial crises. There is also clearly scope for improving the risk understanding of senior executives and board members in financial firms, not to mention the regulators overseeing them.

Three ideas seem to me to be especially relevant to the current debate. About a year ago I interviewed the economist Robert C. Merton for Harvard Business Review and he proposed some simple securities-market reforms that he believed would significantly improve the safety of the financial system and could arguably have mitigated the collapses of AIG, in which the government had to infuse some $165 billion and which is widely seen as one of the triggers of the 2008 credit crunch:

Central Clearing. Under this proposal all standard (i.e., non-customized) securities transactions in any given market would be centrally cleared — registered and processed at a single point. This would in effect net the credit risk exposures of all the counterparties and would enable regulators to tell in real time just how many institutions were exposed by how much and to whom for any particular type of financial instrument.

Professional Margin Collateral. Under this proposal, institutions that were in the business of trading securities would be required to post cash margins, to be adjusted daily to reflect their net exposure to other financial professionals. Effectively, this is a form of ensuring capital adequacy on the part of institutions like banks that can manage collateral at low cost and engage in transactions with each other in large size, thus representing the greatest source of systemic risk. Margin-posting requirements would not be required of non-financial businesses in the market in order to manage risk, because managing collateral is expensive for them and they are not a source of systemic risk.

Mark to Market Accounting. In order to be able to gauge a firm's exposure to risk and assess its margin needs you need to have a clear idea of the value of its assets and liabilities. Requiring firms to value on a frequent basis by referring to market prices or an agreed pricing model — an approach called fair value accounting — would introduce considerably more transparency into the financial health of firms in the financial system, allowing counterparties and regulators to recognize risks early enough to do something about them. (To avoid unintended pro-cyclical pressures from capital ratio requirements, the asset and liability values used for these ratios could be calculated with reference to different accounting systems or the regulator could change capital ratio requirements in response to market conditions.)

These specific proposals are, of course focused on derivative markets, and do not really apply to many of a banks' traditional activities. Nonetheless, the beauty of Merton's proposals is that they are non-invasive. They do not, in and of themselves, require radical, expensive changes in the operations of the institutions they affect and would be relatively simple to introduce and oversee. Yet they would go a long way to addressing some of the market failures that brought the credit markets to a halt.

A pity they don't sound like a declaration of war on big, profitable banks.

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