SGHOUSING.COM 新加坡房地产网

Aim should be to make it less vulnerable to shocks while fostering innovation and flexibility

THE current financial crisis cannot be solely blamed on the shenanigans of financiers. There are two other big culprits for the bubble that preceded the bust: cheap money in the West, the high priest of which was Alan Greenspan, the former boss of the US Federal Reserve Board; and cheap money from the East, mainly China.

That said, the excess greed and foolish risk-taking engaged in by the financial industry magnified the bubble. The way Fannie Mae and Freddie Mac helped pump up the US housing market on the back of quasi-state subsidies is just the latest chapter. If the financiers had not run amok, the global economy would not be in the mess it is today.

The US Congress and various other official bodies around the globe are currently debating what reforms are needed. The starting point should be to recognise that in a healthy financial system, capital is efficiently channelled to the investments which offer the highest risk-adjusted expected returns.

There is no perfect way to assess either expected returns or the risk that expectations won’t be met. But free capital markets do the job pretty well, at least in theory.

Capital markets are guided by two contrary emotions: greed and fear. Greed for higher returns entices investors to risks; fear leads them to avoid excess risk. When markets are healthy, the two emotions are finely balanced.

Problems emerge when that emotional balance is lost, in particular when the fear neurons are anaesthetised. And that, unfortunately, is precisely what happened in the decade running up to 2007. Greed was unleashed, caution was thrown to the winds and foolish investments were made. Economists use the quaint phrase ‘moral hazard’ to describe the problem.

There were five main ways in which the markets have been distorted to favour excessive risk-taking:

Previous bailouts. Whenever financial markets got into trouble - for example after the Long-Term Capital Management Crisis of 1998 or the bursting of the dotcom bubble - Mr Greenspan could always be relied upon to rush to the rescue by cutting interest rates. This phenomenon became known as the Greenspan ‘put’ - on the theory that the central banker had created a safety net under the markets that operated a bit like a ‘put’ option. The current round of bailouts - notably last weekend’s package of measures to support Fannie and Freddie - will further underline the view that in finance the profits are privatised but the losses get socialised.

Heads-I-win, tails-you-lose pay structures. Whether they worked as traders, hedge fund managers or private equity barons, many of the smartest folk in the City or on Wall Street had skewed incentives. If markets boomed, they made out like bandits. If they tanked, well, most of the time clients’ money went down the drain.

Tax breaks for debt. In most countries, corporate interest payments are tax deductible. Not surprisingly, that provides an incentive to companies and investors to leverage themselves up to the gills. The private equity industry, in particular, gorged itself on debt during the bubble years. But excess debt is risky when hard times hit. Loans to leveraged buyouts are already clogging up bank balance sheets.

Ill-conceived capital requirements. Banks are required by their regulators to hold enough capital to cushion themselves against losses. The problem is with the way this capital requirement has been calculated. In boom times, bank balance sheets look superficially healthy and lending doesn’t look risky.

So the regulatory formula allows banks to pile on their lending. In other words, the more markets bubble away, the more risks banks are encouraged to take. The regulatory system is - to use the technical term - ‘pro-cyclical’. That’s crazy.

Inadequate liquidity premiums. In the good times, credit was bubbling and all assets seemed equally ‘liquid’. It was possible to get a fair price in cash for pretty much anything - sub-prime mortgages, leveraged loans, entire companies - at a moment’s notice. Not surprisingly, investors engaged in a large variety of ‘carry trades’ - borrowing cheap short-term money and investing in long-term assets (especially real estate) which offer higher returns. When the dancing stopped, investors were stuck with assets they couldn’t sell - and the previous profits were revealed to be a mirage.

Skewed incentives were not the only reason the financial system ran amok. There was also incompetence at pretty much every level. Start with the investors. Most didn’t understand the complex products they were buying. They didn’t do their own homework. Instead, they blithely relied on assurances by ratings agencies that this or that product was a triple-A credit.

Now look at the young traders and bankers. Few had historical perspective - and so they didn’t realise that bubbles have a habit of bursting.

Older bankers had been through various cycles. But they didn’t understand the new-fangled financial technology based on derivatives and slicing and dicing risk. They were largely dismissed by their younger colleagues as fuddy-duddies.

The banks’ non-executive directors weren’t any better. Many did not understand enough about finance to assess the risks the banks were running and, hence, to hold the executives to account.

Finally, there were the regulators. They were too weak to control the banks. It’s hardly surprising. Regulators aren’t paid much money. The investment banks poached any bright sparks they saw by offering them large multiples of their previous compensation. The talent pool was hollowed out.

So much for the analysis of what went wrong. But what is to be done?

The overall goal should be to make the financial system less vulnerable to shocks, while continuing to foster innovation and flexibility. This can be party achieved by discouraging foolish risk-taking in the first place; and partly by ensuring that the financial system has big enough capital cushions and liquidity reserves to absorb shocks without a heart attack. Pumping up capital and liquidity is largely a matter of regulatory diktat. It won’t be easy to get global consensus. But the wheels of various international committees - mainly the Group of Seven and the Basel Committee - are already grinding away.

The more complex matter is how to discourage foolish risk-taking. A twin-track approach is required. First, there needs to be more fear so that there is less incentive for market participants to run amok with other people’s money. Here are some ideas:
Miscreants must now be made to suffer as much pain as possible - so that this crisis is seared in their memories. Bank bosses who have lost money should see their bonuses curbed, shareholders should have their dividends cut and more capital should be injected into the system (again diluting shareholders).
Central banks must take an active interest in keeping unhealthy excess out of the financial system.
Heads-I-win, tails-you-lose compensation structures should be squeezed out of the system.
The tax deductibility of debt should be abolished. In addition to rebalancing incentives, financial markets need to operate more intelligently.
There should be much less reliance on ratings agencies, so that investors have to do their own homework.
Bankers and brokers should be forced to study financial history before they qualify.
Banks’ directors should endure a ‘Star Chamber’-style inquisition to check they are up to the job before being appointed.
The risks banks are running should be exposed to public scrutiny. That will allow the market to discipline peers who are taking excess risks. Such ’sunshine regulation’ could complement the regulation of officials, who will always be behind the curve so long as their brightest colleagues are poached.

Some people will argue that such a package of measures would strangle the financial system with excessive red-tape.

There will certainly be consequences - above and beyond the main purpose of making the system less vulnerable. Most obviously, banks with more capital that take fewer foolish risks will earn lower returns on equity in good times. In turn, that will lead to less extravagant rewards for financiers. And lower prospective pay will mean that less of the world’s talent will be attracted to the money-pots of the City and Wall Street.

But would this really constitute collateral damage? More like a collateral benefit. If less talent is sucked into Wall Street’s greed game, more would be available to go into industry and the professions. It’s not just the market’s balance of fear and greed that would be improved. Better regulation would lead to healthier balance throughout the economy.

Source : Business Times - 24 Jul 2008