Book Review: Restoring Financial Stability
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Central to the case for reform is the emergence over the past 25 years of LCFIs (large, complex financial institutions), which by virtue of their size and interconnectedness give rise to systemic risk. The issue is compounded by the mispricing of the government’s express or implied guarantees to such institutions. Mispriced guarantees to institutions deemed “too big to fail” effectively create incentives for risk taking or for engaging in regulatory arbitrage through, for example, the use of off-balance-sheet vehicles to reduce associated capital requirements and increase leverage. The contributors also make the case that this type of mispricing in and of itself encourages financial companies to grow to systemic size and complexity in order to compete. They contend that regulation is a key quid pro quo for providing systemic guarantees, and suggest extending appropriate reporting and disclosure requirements to the shadow banking system, possibly including hedge funds. They also point out that, given the global nature of many LCFIs, effective regulation must include mechanisms for international coordination.
Strong emphasis is placed on flaws in incentive compensation, including the lack of incentives to assess risk in the “originate to distribute” securitization model. The suggested solutions include, for example, requirements that originating banks keep representative loans on their balance sheets, and spreading payments over time based on a given securitization transaction’s credit experience. In “Rethinking Compensation in Financial Firms,” the authors indicate that the widespread use of return on equity as a key performance metric for senior executives likely provides incentives to increase leverage. They propose the use of return on assets as a more balanced metric.
In “The Rating Agencies: Is Regulation the Answer?,” the authors point out the potential conflicts of interest associated with the “issuer pays” model, and highlight model specification issues inherent to rating complex securities for which the claims effectively constitute compound put options such as CDOs (collateralized debt obligations) of residential mortgage-backed securities, or CDOs of CDOs. Interestingly, given margin call provisions’ current reliance on ratings, the paper comes out as generally in favor of “rating through the cycle,” even though the authors feel this gives rise to ratings which may change too slowly under certain conditions. Ideas for reform include the potential for regulatory administration of ratings mandates (to prevent issuers from shopping for ratings), or eliminating the concept of a nationally recognized statistical rating organization. The latter would place the onus on regulated financial institutions to use their own methods—justified to a regulator—to assess the quality of fixed income securities. Such methods could include the use of outside ratings as inputs.
Thomas F. Cooley and Andrew Caplin take the US government to task for avoiding a fundamental problem: the likelihood that homeowner mortgage defaults will lead to deadweight social costs and higher losses for the financial system. Their solution is a debt-for-equity swap, in which a homeowner’s principal balance is reduced in return for a share in the appreciation of the home’s value. In a separate paper, Cooley and Thomas Philippon question whether the government has adequately formulated its eventual exit from bank recapitalization programs and guarantees. If not, maintaining high liquidity indefinitely could give rise to the next crisis.
Despite an arguable bias toward regulation, Restoring Financial Stability ably tackles complex issues and covers a wide spectrum of the current debate, including the multiplicity of regulators, the need for international regulatory coordination, transparency, fair value accounting, compensation reform, and the extent to which monetary policy should address systemic asset bubbles. Several of the ideas in the book, a draft of which was distributed to lawmakers and administration officials in December 2008, are in fact incorporated in the US Treasury’s June 2009 proposals for financial reform.–Costas Chrysostomou, CFA, is a corporate finance analyst with Moody’s Investors Service.