Monday, December 15, 2008

The Financial Crisis II: Everything Old is New Again

The Pennsylvania family I mentioned in my last post can add to their accomplishments causing a constitutional crisis in Canada, nearly wiping out the North American auto industry and prompting a purportedly conservative U.S. government to effectively nationalize many companies. On the bright side, it seems they also caused Bernie Madoff's alleged record-breaking fraud to be exposed.

The crisis has also triggered regulatory responses. Some of these were taken from playbooks of yesteryear, such as imposing restrictions on short sales. Some were the opposite of actions taken in the past; the Glass-Steagall Act was passed in 1933 mandating the separation of banking functions so that customer deposits could not be put at risk by investment banking activities. This year, the remaining independent investment banks were allowed to become bank holding companies, shoring up their capital base in return for greater government prudential oversight.

The finger-pointing has already begun, with an unseemly rush by regulators to blame other regulators for the fallout. The Federal Reserve argues it didn't have the authority to prevent the collapse of Lehman Brothers, while the SEC argues its mandate is investor protection, not prudential regulation. It is clear that at least two significant gaps are in the regulatory regime. There are significant transactions taking place in a completely opaque, unregulated environment. To make matters worse, no single regulator could see the potential impact of these transactions on regulated entities.

The Overall Regime

How these will be addressed is far from certain, but I will venture a few predictions. The first is that the regulatory regime in the United States will be overhauled (there is less need of a comprehensive overhaul in Canada). Regulation of derivative trading has traditionally had a light touch (except for a ban on trading onion futures) on the basis that everyone in the market was a sophisticated player. Clearly, they are not sophisticated enough. Therefore, I predict that the coming year will see more comprehensive regulation of option, futures and insurance contracts, possibly with a requirement to clear all over-the-counter trades through a new central clearing house that would establish maximum risk parameters. There may be a merger of the SEC and the CFTC, but more effective would be a single prudential regulator overseeing the financial health of banks, broker dealers and insurance companies. This will be coupled with greater financial disclosure requirements and stringent requirements to stress test various potential scenarios regardless of their likelihood.

This will create a tension as prudential and traditional securities regulation will sometimes be at cross-purposes. If a bank is experiencing difficulty, a prudential regulator may want it kept quiet to avoid a run on the bank while it attempts to shore up its capital. A securities regulator would insist on immediate disclosure.

In Canada, the banks and brokerages are in much better condition, perhaps because of greater conservatism. That being said, the crisis should bolster the call for a single national regulator that will have jurisdiction over the entire brokerage industry.

The crisis should also provide a stimulus for harmonization of international bankruptcy rules regarding things such as set-off rights.

Other Regulatory Responses

I will state for the record that I am unconvinced that the restrictions on short selling are necessary. I have seen nothing that convinces me that short sales have exacerbated the downward spiral of the markets, and removing exemptions for market makers will only hinder their ability to smooth-out price swings. That being said, the position of regulators world-wide appears to be entrenched and I doubt we will see any easing of restrictions on short sales any time soon.

We will probably also see a clamp-down on sales practices and not just in the brokerage industry. In Canada and the United States, selling asset-backed securities on the basis that they are as safe as houses has tied up a lot of people's savings indefinitely, and predatory mortgage lending in the U.S. has rendered houses considerably less safe. We can probably expect a tightening up of exempt transactions along with more detailed and focused risk disclosure requirements.

In Canada, sales of asset-backed securities were exempt if the securities had a credit rating. Credit rating practices have been called into question, and we can expect to see credit rating agencies subject to greater regulation and possibly self-regulation.

We may also see new financial certification coupled with stress testing requirements for public companies. This may be counterproductive; arguably one of the causes of the current mess is that the Sarbanes Oxley Act has forced management to focus on the wrong things.