Thursday, June 18, 2009

Financial Well-Being and Regulation: the Obama Effort

Financial well-being is, in many ways, analogous to our physical well-being. We need periodic check ups and doctoral oversight, but in general true health is dependent upon the discipline and persistence and care that we bring to our own daily lives. However in other ways financial well-being in not the same. Our physical existence is limited to our natural selves: there are limits to how humans can grow and change. This is not true of the financial system.

In the world of finance we can innovate and change and find ways to get around regulation. This has been the modus operandi of the financial system during my entire professional career. Consequently, the financial system of today in substantially different than the financial world that existed in the 1960s. I have called the last fifty years or so the age of financial innovation. Regulation and oversight of the financial system does have to change. But, we need to be careful about the change in regulation and oversight that results and not just give in to populist calls to “put a stop to the greed on Wall Street”.

The characteristic about finance that fails to be taken into consideration when people believe that they can “control” finance is that finance is about nothing more than information. Finance is numbers, nothing more, and numbers can be packaged in any way that a person wants to package them. On our currency we read that “This note is legal tender for all debts, public and private.” That is, people and governments can pay you for things in this script and you must take it. And, what more is a check, or a bank deposit, or a bond, or a stock certificate? In most cases today, these are nothing but 0s and 1s in a computer system. Finance is nothing more than information and how information is handled and transformed.

The unique thing about information is that it spreads and, as we have found out historically, information cannot be contained. Of course, its spread can be postponed or stymied for a while, but eventually its spread takes place. All human history is a record of this fact.

We see this trend also works in non-financial areas. Information relating to modernity and science and democracy is spreading throughout the world. In some areas this spread is being resisted by some who are attempting to keep the world mired in the ideas of the 7th or 8th century (C. E.) This attempt to prevent the spread of the idea of the modern world has resulted in violence and tremendous pain to many. But, the spread continues. It has all through recorded history. In the end, the resisters cannot stop it and their efforts to slow it down do nothing but cause unhappiness and dislocation.

The financial system over the past 50 years or so has been an engine of new creations. In the 1960s, we saw the movement of banks from being asset managers to becoming liability managers through the creation of instruments like the negotiable certificate of deposit and Eurodollar accounts. This broke down the geographical limitations on banks and helped them continue to evade government rules and regulations. In the academic world increases in computing power combined with the vast amount of data available on the stock market allowed for the development of ideas relating to portfolio management and risk control, which culminated in the creation of CAPM and the efficient markets hypothesis. A third innovation related to the growth and development of venture capital that put money into the hands of more and more innovators starting up small businesses. All of these developments had to do with information and how that information was bundled and traded.

In the 1970s we saw the development of the mortgage backed security, the junk bond, and the leveraged buyout. The creation of the mortgage backed security by the federal government was the test case for “slicing and dicing” up cash flows into tranches that could be packaged in ways that met the specific needs of different investors. And, as they say, the rest is history.

The development of the junk bond? The legend is that Michael Milken, sequestered in the bowels of the Lippincott Library of the University of Pennsylvania discovered information about the performance of “fallen angels”. These were high quality bonds issued sometime in the late 1920s or early in the 1930s whose companies had had financial difficulties. The bonds fell out of favor and hence yielded very high returns. Milken discovered that because of the lack of interest in these securities their actual performance substantially exceeded the performance exhibited in their market pricing. This information, which was confirmed by more current information, led Milken to develop the junk bond, the first such issue coming to market in 1976.

In addition, fund managers arose, like KKR, which discovered information concerning the value of assets that were on the books of many corporations. Often, these assets were undervalued because they were recorded at historical values and were substantially below current market values. Previously, these companies were “out-of-reach” of corporate raiders, but with the creation of the junk bond, all companies in the United States came within the reach of well-funded organizations. So, finance could now reach the largest, as well as the smallest, businesses.

This evolution, of course, continued into the 2000s. The point is that as information becomes available it can be used in many different ways to serve many different purposes. “Slicing and dicing” the information known as cash flows is not new, but is a part of a process that has a long history. And, due to the nature of information this process is not going to go away.

The Obama administration is now making its attempt to re-regulate financial institutions and financial markets. The proposal offered yesterday is much watered-down from what the “more progressive” wing of the political spectrum had wanted: its thrust is not sufficiently “Rooseveltian”. Still others express concern that the administration is going too far in some areas.

My take on the Obama proposals for financial regulation: it will make little difference in the end. Obama needs to take some kind of action and look like he is attacking the problems faced by the society. In the longer run the new regulatory scheme will make very little difference.

Financial innovation is going to continue. If some efforts are constrained in the United States, they will pop up elsewhere in the world. The incentives to innovate are still there. If we force the innovation to go off-shore, then we are, in my mind, the losers. This innovation will help others but provide little benefit to us.

What is needed? To me the most important thing that is needed is openness and transparency. We need to know what is being done and by whom. As derivative securities and hedge funds grew and prospered, we heard over and over again that they could not tell anyone what they were doing because, if they did, the narrow spreads they were working with would go away. Well, guess what! Most everyone knew what deals were being struck and the spreads went away anyway. That is why these organizations needed to use more and more leverage to take on riskier and riskier deals.

Highly competitive markets where there are few if any barriers to entry cannot continually provide exceptional returns. “Trading” is not the source of sustainable competitive advantage and keeping things secret will not salvage trading schemes. Openness and transparency will result in financial institutions focusing on what really creates competitive advantage and what is sustainable. This is necessary for the existence of a strong and healthy financial system.

Secondly, we need methods to close or put-out-of-business in a more timely fashion financial institutions that are troubled or are insolvent. Re-instating and improving mark-to-market accounting is a must. Increased openness and transparency should help the market place carry out this function, but, the regulatory system needs to have more FDIC-type efficiency to move quickly into institutions and shut them down. (The Federal Reserve is not the institution to do this. It needs to keep its focus on the conduct of monetary policy.) Moving quickly to resolve problems has always been the best policy. Managing institutions based on wishful thinking, a major trait of the banking system, is not a good policy.

We need financial regulation and oversight, just as we need periodic checkups and advice from doctors. However, there is only so much that regulators can do. Unlike our physical systems, our financial systems are going to innovate and change. My guess is that in the future with the continued advancement of information technology financial innovation will continue to increase rapidly and will serve as the model for more and more of our non-financial markets. “Information markets” is the model for the future. This innovation will, in one way or another, get around whatever regulation that is imposed. That is why openness and transparency is so important. But, that is also why the system of failure and bankruptcy should be enhanced and enforced. These, to me, are the major requirements we should impose on the financial system.

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