Henry Kaufman On Large Financial Conglomerate Regulation

Henry Kaufman wrote an editorial in today's Wall Street Journal entitled, "Who's Watching the Big Banks?"

Kaufman writes, in part, in his piece,

"The problem is that the Federal Reserve and Treasury have failed to come forth with solutions that will limit future financial excesses. They've also failed to keep pace with a series of fundamental structural changes that have transformed markets in recent decades. As a result, in an age when "transparency" is the business watchword, financial markets have become increasingly opaque. This in turn has fostered doubts and fears about the underlying strength of markets and their institutions. Compared with a generation or even a decade ago, financial markets today are much more complex, an order of magnitude larger, and filigreed with new and often arcane credit instruments. Risk taking -- driven by the mystique of quantitative risk modeling -- has become more aggressive. And these structural changes, many of which were initiated in the U.S., are rapidly gaining acceptance in other major financial centers around the globe.

This new, highly securitized financial regime can work well only if securities are priced accurately. Stated differently, weaknesses and failures in securities pricing are wreaking havoc in financial markets. Traders and investors are learning the hard way that not all assets are the same when it comes to pricing. There is a sharp difference between marking-to-market U.S. government securities or large high-quality private-sector issues versus lower quality issues for which pricing is done off a model or matrix."

Kaufman covers a lot of ground in just these two paragraphs. His first statement is a contention worth pondering at length,

"The problem is that the Federal Reserve and Treasury have failed to come forth with solutions that will limit future financial excesses."

Is it? Is this actually what we wish these entities to do? Are the Fed and Treasury primarily in place to limit future financial excesses? More on this a little later in this post.

Kaufman's second contention, following the first, is,

"They've also failed to keep pace with a series of fundamental structural changes that have transformed markets in recent decades."

This statement is, I believe, easier with which to agree. And, on the face of it, true, in terms of the two entities, the Fed and Treasury, having the ability to do much about these new forms of credit monetization.

Later in his thoughtful piece, Kaufman proposes,

"What is urgently needed is a new kind of institution that I will provisionally call the Federal Financial Oversight Authority. This regulatory body would oversee only the largest U.S.-based financial institutions -- the giant conglomerates engaged in a broad range of on- and off-balance-sheet activities that I noted above. The new authority would monitor and supervise these huge financial conglomerates -- assessing the adequacy of their capital, the soundness of their trading practices, their vulnerability to conflicts of interest, and other measures of their stability and competitiveness.

I am not proposing comprehensive supervision of most or all financial institutions. Oversight of the 10 to 20 largest financial conglomerates would fill the much-needed regulatory void, given the vast reach of those dominant players. The 15 largest institutions in the U.S., for example, have combined assets of $13 trillion. They dominate many key areas of trading, underwriting, and investment management. Many command an overwhelming position in derivatives and in many of the esoteric financial instruments that have grown so rapidly in the past decade.

This is not to say that other financial institutions should be allowed to do what they please. For them the current official regulatory and supervisory authorities should remain in place. But insuring the safety and soundness of the dominant firms would go a long way toward assuring the smooth functioning of financial markets, even if smaller institutions occasionally failed.

The new Federal Financial Oversight Authority should function under the auspices of the Federal Reserve because its insights into market developments would fill the present-day void in central bank deliberations on monetary policy. To underscore the importance of the new Authority's mission, it should be required to submit annual reports to Congress on the safety and soundness of the financial institutions under its purview. And in light of the increasing globalization of financial institutions, other leading economies throughout the world should consider a similar approach. There, too, relatively few institutions would come under supervision, because financial conglomerates dominate throughout the leading nations of the European Union as well as Canada and Japan as they do in the U.S."

I confess to not being swayed by Henry Kaufman's plea for yet another, albeit, super financial regulatory agency. Underscoring its importance by reporting to Congress means nothing. It only assures us that the appropriate head of said agency would cover his/her ass equally appropriately and carefully, knowing full well that any subsequent burp by the financial markets would immediately be charged to that official and, by extension, directly to the sitting Secretary of the Treasury and the President.

To me, the more interesting and relevant questions are those in my set following the first quotes from Kaufman's article.

Do we indeed want the Fed and Treasury to be the lead in limiting future financial excesses?

This itself presupposes another important question- Can we, in any meaningful capacity which does not infringe on individual rights, limit future financial excesses?

I'm not at all sure that each of us, individually or, collectively as a corporation, does not have the right to engage in financial excess.

I don't think any government agency will ever succeed in limiting or preventing financial excess. The post-Depression fixes of Glass-Steagal and unitary, single-state banking laws only lasted a comparatively brief 70 years. Global trading, differing sovereign regulatory environments, and technology proved too much for them to handle.

Between the invention of Eurobonds in the 1960s, ubiquitous credit cards, Merrill Lynch's CMA account, commercial paper, etc., the financial regulatory framework of the US circa 1933 became totally overwhelmed. Upon that contention, I agree with Kaufman.

But he misses the fundamental lesson of this current reality. Whatever rules, agencies, etc., are devised, intelligent, greedy minds on Wall Street and, in imitative fashion, among commercial bankers, will find ways which exploit the clear, well-defined and, thus, self-limiting language of such regulations.

To me, the more interesting and important point is how our financial market participants have liquified heretofore untradeable risks.

For instance, the creation of 'money' via private issuance of credit instruments, culminating in private equity firms going 'public,' pretty much has ended any hope of Treasury and the Fed rigorously controlling dollar-denominated money creation as it could back in the late 1950s. Nobody seriously thinks about DDA account limitations or credit card regulation anymore.

We've seen 40+ years of vibrant, constant financial innovation in US markets, since those first offshore Eurobonds were issued to avoid a Treasury-mandated holding tax in the early 1960s.

How do we expect anyone inspecting the books and records of various large US financial entities to actually preclude a financial crisis? Until defaults and credit freeze-ups occur, who can say what is good, and what is bad? Further, do we want any governmental bean-counter to blow a whistle and declare the legal actions of any large US financial institution to be wrong and dangerous?

Who among us believes that anyone working for Federal government scale is qualified and motivated to make that decision correctly?

No, I don't think any governmental regulatory initiative, even that proposed by Kaufman in his Journal editorial, can pre-empt painful financial excesses.

The best I think we can hope for is to limit the damage of financial excesses.

Today, this is generally done via careful counterparty trading vetting. Most large entities won't trade with entities which have not gained access to trading systems without the assurance of sufficient liquid assets, or collateral, to settle their obligations. We don't need to 'belt and suspender' this area. We can trust private parties to generally police each other with regard to settlement risk.

It seems that the major new risk we have encountered is the inability of various parties, some of whom are large, diversified US financial institutions, to distinguish between listed, truly liquid financial instruments, and structured financial instruments.

Hmmm. Funny, how that name is so prominent, isn't it?

Structured......financial instrument.

To paraphrase the currently, seemingly endlessly-running New York Times 'Weekender' ad concerning the word 'weekend,'

"the word alone makes me suspicious."

There are liquid markets for a wide variety of financial instruments: small, medium and large-cap equities, corporate bonds, corporate and bank commercial paper, US Treasuries and bonds, listed options and futures, commodities, commodity futures.

All of these tend to be self-explanatory, and require either full payment, or some carefully regulated, collateralized situation to exist in order to trade.

To my knowledge, nobody, i.e., financial institution, has ever stepped forward and pledged to be a 'market maker' of structured financial instruments.

My friend B, a longtime business colleague, sometime business partner, and creator of one of Wall Street's larger mortgage businesses, had an interesting take on this whole question some years ago.

He opined that perhaps the basic business of deposit-taking should be, once again, a la Glass-Steagal, separated from all other activities. To safeguard the basic banking system, he thought that making it into a sort of simple, financial utility, capable of taking consumer deposits, insuring them, and investing in only the safest financial instruments, would go a long way toward quelling many fears of financial excess damaging our basic credit and banking systems.

In today's world, I'd add that such utilities would be forbidden to invest in any structured instruments. That, to qualify for FDIC insurance, they could only invest in instruments that were AAA rated and unstructured. A sleepy business, to be sure. Such deposits, of course, would earn the lowest rates available in the financial markets, because there would be absolutely no possibility of the financial utility to take extra risk with the deposits and make a larger spread.

Anyone wishing more return would, of course, be obliged to take more risk.

But even B's suggestion doesn't really address Kaufman's central question. Or, more properly, the central question which has occurred to me, in light of Kaufman's thought-provoking piece in the Journal today.

Do we actually want to limit financial excess? That is, financial innovation and technological advances? Or do we simply want to limit the damage of financial excesses, gone wrong, to those who knew the risks, and had already been vetted as capable of withstanding the losses thereto?

In the final analysis, I don't believe Kaufman's focus is correct, nor his solution probably effective to actually preclude the next financial excess. It's just the nature of our financial system.

People stand to reap handsome rewards from intelligent, well-managed financial innovations. Structures like private equity, hedge funds, mono-line mortgage banks and credit card companies come to mind. Even the original, residential-finance-only CMOs probably constituted a reasonable advance in housing finance.

But mixed-asset CDOs crossed a threshhold of ability to be easily priced and to assume a continuous market for the instruments. And, to my knowledge, thus far, the only victims are the sophisticated purveyors of these instruments, and their sophisticated institutional investors/buyers.

It may be financial excess, but I still seriously doubt it's either preventable, nor desirable to create significant new regulatory structures to attempt such prevention.