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Wall Street sign (Mark Lennihan)
Wall Street sign (Mark Lennihan)

Expert's Podium

Learning the right lessons from a crisis Add to ...

It's been hard to miss recent accusations that Goldman Sachs "bet against its customers", structuring a deal in which hedge fund manager John Paulson made $1-billion (U.S.) while some European banks lost the same amount.

In talking to Bay Street insiders, few were surprised. The only thing that took people aback was that Goldman Sachs' fee on this transaction was a paltry $15-million. (The $200-million to $300-million that Goldman Sachs earned for a structure that allowed Greece to mask its debts was closer to the norm.) Getting past the headlines, you now find proposals from governments around the globe for better ways to regulate the financial industry, with big implications for consumers and businesses.

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While it's natural to look for quick and easy solutions, these are typically hard to come by. Here are comments from academics and industry observers on some of the key decisions on the horizon.

Changing the rules on derivatives

Currently, many derivative transactions are direct contracts between buyers and sellers. There is broad consensus among regulators to force derivatives onto central exchanges, increasing transparency and imposing collateral requirements.

However, there are cautionary voices.

Laurence Booth of the Rotman School at the University of Toronto maintains that this could drive up the cost of derivatives and hurt companies such as airlines that need to hedge fuel costs.

Dr. Dan Rosen, CEO of R2 Financial Technologies raises another concern. An authority on risk management who consults with financial institutions around the globe, he points out that with multiple exchanges, price competition may reduce the exchanges' capital to cover possible defaults, potentially increasing systematic risk. Further, multiple exchanges could increase counter-party risk by making it more difficult to offset exposure to a particular firm.

So, with derivatives, there is concern out there that cumbersome new policies will be implemented that increase costs without addressing the issues that contributed to the financial crisis.

Derisking banks

Another proposal with broad support comes from Paul Volcker, Alan Greenspan's predecessor as Chair of the Federal Reserve Board and current Obama administration adviser.

Mr. Volcker has proposed a limit on the size of banks and a ban on banks engaging in proprietary trading or trading for their own account.

Proprietary trading's profile was raised last week with reports that trading for their own account resulted in Goldman Sachs and four other banks making at least $25-million on each of the 61 trading days in the first quarter. In fact, proprietary trading has become the main profit engine for firms like Goldman Sachs.

Mr. Booth expresses concerns about the difficulty of separating the necessary market-making activity by banks from trading for their own accounts. Former U.S. Treasury Secretary Hank Paulson is even more critical, pointing out that these proposals would not have prevented the collapse of Lehman Brothers, AIG or other institutions that contributed to the crisis.

Mr. Paulson's view is that simplistic solutions risk creating complacency if they don't address the core problems of regulating increasingly complex financial institutions.

Complexity and innovation

A third proposal relates to reducing complexity.

I recently spoke to Roger Lowenstein, long-time Wall Street Journal writer and author of The End of Wall Street. He spoke of the need to reduce complexity so that we never again have senior management of large banks unable to understand the risks they're taking.

A contrary view comes from John Cochrane of the University of Chicago Booth School of Business and current President of the American Finance Association.

In a conversation in January, Prof. Cochrane pointed out that the much-maligned credit default swaps engineered by Wall Street actually prevented the crisis from being worse. By syndicating mortgages widely, local lending didn't collapse as it did in the Great Depression, because losses were widely dispersed rather than concentrated in one local bank.

Prof. Cochrane points out that innovation is critical for the financial system to function effectively and expressed a hope that in the backlash against complexity we don't lose the scope for meaningful innovation.

The role of incentives

There have been lots of culprits fingered for the subprime mess: greedy homeowners and mortgage officers; complacent banks; oblivious rating agencies; the rapacious traders who packaged flawed mortgages and the clueless money managers who bought them.

Dr. Rosen points out that everyone in this chain acted rationally based on their short-term incentives. To avoid future problems, we need a fundamental restructuring of incentive systems to ensure that individual incentives are in line with those of the system as a whole. That's already started happening at banks, as there's a move afoot to have bonuses paid out over a number of years rather than annually.

Early on in the financial meltdown, President Barack Obama's chief of staff was quoted to the effect that "it would be a shame to waste a good crisis."

For all the pain that we've endured over the past couple of years, there may be some redeeming value if we learn from the experience - provided that the lessons we take away are the right ones.

Dan Richards is president of Clientinsights. He is a faculty member in the MBA program at the Rotman School at the University of Toronto. dan@clientinsights.ca

 

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