Rajan on financial regulation

Chicago finance b-school prof Raghuram Rajan has a stimulating piece in this week's Bloomberg Business Week about how to make financial regulation more effective. Rajan focuses on tail risks, in particular events such as a crash in housing prices that have low odds (at least in the minds of most risk modelers three years ago) but severe outcomes. Banks are not afraid to take on these risks because current regs skew the game -- heads they win and tails we lose.

Rajan recommends that banks' capital requirements be increased, that way equity holders have more to lose if tail risk raises its ugly head again (which it will). He also wants to put debt holders on the hook by having some debt automatically convert to equity if the bank suffers significant losses. Also, other financial institutions would not be allowed to hold each other's debt to avoid contagion issues (remember that's why AIG got bailed out). The overall idea is to make debt holders more fearful that the government will not bail them out 100 percent next time. Maybe the debt would then be priced to reflect the true amount of tail risk.

In effect Rajan trusts debt holders and equity markets to do a better job of managing risk than simply adding more federal regulators and regulations.

Obamacare: an insurance CEO's view

Today's WSJ features a long interview with WellPoint's CEO Angela Braly. Whether you agree with Braly or not, she does a particularly effective job in presenting her point of view. She does a good job of explaining what would have happened in the insurance market if there was not an effective mechanism to force everyone to enroll. She also suggests that consumers need to have both the incentive and the information (through data analytics) to make cost-effective decisions.

If Paul Volcker had a hammer ...

According to NYT blogger Simon Johnson (Sloan MIT prof and former chief economist at IMF), former Fed chair Paul Volcker is going rogue on the Obama administration by pushing for much tighter regulation of the financial services industry. Although Volcker was originally going to be a senior economic advisor to the President, he has been eclipsed by Larry Summers and Treasury Secretary Tim Geithner. Now that financial services regulation is moving to the front burner in both the House and the Senate, Big Paul (he is 6'7" in case you wondered) has picked the perfect time to make his pitch.

Monday's WSJ had an interview with the former fed chairman where he shared the following insights: (1) forget CDOs, the most important financial innovation in the last 20 years is the ATM; (2) there are huge moral hazard issues; and (3) commercial and investment banks need to be separated. It will be interesting to see how Volcker's arguments influence the upcoming deliberations.

What to do with TBTF banks?

Stimulating piece in today's Financial Times by Harvard Business School professor Niall Ferguson (also has an appointment in the history department) about TBTF (too big to fail) banks. Professor Ferguson is quite disappointed with the proposals on the table (in both the US and Europe) to deal with these institutions. "Very strong government oversight" is needed, says Treasury Secretary Geithner -- but what does that mean and weren't we already supposed to have that before all of the bailouts? Ferguson's take:

This is moral hazard run mad – a system in which a few giant banks get to operate as hedge funds with a government guarantee that if they blow up, their losses will be socialised.

Ferguson's solution: make a credible commitment that in the future bondholders as well as stockholders will be wiped out the next time a big bank goes belly up. But can the Obama (or any) administration pull this off? How often does "this time we really, really mean it" work in other settings?

Should the Federal Reserve regulate bank pay practices?

News leaked out late last week that the Federal Reserve was considering adopting a new policy that would allow it to regulate the pay policies of banks. The rules are vague, to say the least. There would not be a cap on pay or bonuses, but the Fed would look at issues such as how long should deferred compensation be deferred and whether banks can reclaim bonuses and stock grants in certain situations.

As my MBA 505 students know from our discussion last week, there are serious concerns that pay practices have contributed to excessive risk taking. However, those practices have been put in place for a good reason -- to align the incentives of bank executives, traders and other high-level employees with the incentives of stockholders. I can somewhat understand the Fed and the Treasury asserting themselves in banks where taxpayers hold significant stakes -- but for all the banks all of the time?

Many economists maintain that the real agency problem is the Fed's implicit commitment to bail out virtually all failed financial institutions (except Lehman). It will be interesting to see how this plays out.

Will Goldman Sachs be the next Freddie Mac?

Paul Krugman seems to think so in his column in today's NYT. Wait, Krugman must be nuts, didn't Goldman Sachs just report billions of dollars in second quarter profits? But here's the rub: Goldman was one of many financial services companies that was deemed too big to fail last fall. No changes in financial regulation are on the horizon; Congress is focusing on cap-and-trade and health insurance instead and the President seems happy with that. Compensation practices have not changed, as Krugman notes

The huge bonuses Goldman will soon hand out show that financial-industry highfliers are still operating under a system of heads they win, tails other people lose. If you’re a banker, and you generate big short-term profits, you get lavishly rewarded — and you don’t have to give the money back if and when those profits turn out to have been a mirage. You have every reason, then, to steer investors into taking risks they don’t understand.

So what will happen? Bankers will take even bigger risks, one day they will find they have placed their bets on the wrong side, and guess who is left holding the bag? Krugman's take: the government needs to insist on tighter regulations as long as the Goldman Sachs and its ilk are in effect wards of the state. An alternative view I would like to see someone flesh out -- if these institutions are too big to fail, maybe we should bust them up so they aren't too big?