Tuesday, February 10, 2009

Lessons for Financial Sector Regulation

Lloyd Blankfein, the chief executive of Goldman Sachs, offers his explanation of the things that went wrong in the financial services sector which resulted in contagion and the global financial crisis. In his column in the Financial Times, Blankfein outlines the failings and the lessons from the crisis:
- risk management should not be predicated on historic data;
- outsourcing of risk management to credit rating agencies is not a good idea;
- the bigger the exposure the greater the risk;
- assumption of risk models that positions could be fully hedged is wrong;
- failure of risk models “to capture the risk inherent in off-balance sheet activities;
- inability to handle complexity; and
- inaccuracy in accounting for asset values.
He then goes on to say:
“As a result of these lessons and others that will emerge from this financial crisis, we should consider important principles for our industry, for policymakers and for regulators. For the industry, we cannot let our ability to innovate exceed our capacity to manage. Given the size and interconnected nature of markets, the growth in volumes, the global nature of trades and their cross-asset characteristics, managing operational risk will only become more important.”
While emphasis on risk management is the overall them, what are his specific prescriptions? To begin with, there is a clear admission that “self-regulation has its limits”. Apart from that, he adds:
“Capital, credit and underwriting standards should be subject to more “dynamic regulation”. Regulators should consider the regulatory inputs and outputs needed to ensure a regime that is nimble and strong enough to identify and appropriately constrain market excesses, particularly in a sustained period of economic growth. …

The level of global supervisory co-ordination and communication should reflect the global inter-connectedness of markets. Regulators should implement more robust information sharing and harmonised disclosure, coupled with a more systemic, effective reporting regime for institutions and main market participants. Without this, regulators will lack essential tools to help them understand levels of systemic vulnerability in the banking sector and in financial markets more broadly.

In this vein, all pools of capital that depend on the smooth functioning of the financial system and are large enough to be a burden on it in a crisis should be subject to some degree of regulation.

After the shocks of recent months and the associated economic pain, there is a natural and appropriate desire for wholesale reform of our regulatory regime. We should resist a response, however, that is solely designed around protecting us from the 100-year storm. Taking risk completely out of the system will be at the cost of economic growth. Similarly, if we abandon, as opposed to regulate, market mechanisms created decades ago, such as securitisation and derivatives, we may end up constraining access to capital and the efficient hedging and distribution of risk, when we ultimately do come through this crisis.”
Blankfein also addresses the important question of executive compensation:
More generally, we should apply basic standards to how we compensate people in our industry. The percentage of the discretionary bonus awarded in equity should increase significantly as an employee’s total compensation increases. An individual’s performance should be evaluated over time so as to avoid excessive risk-taking. To ensure this, all equity awards need to be subject to future delivery and/or deferred exercise. Senior executive officers should be required to retain most of the equity they receive at least until they retire, while equity delivery schedules should continue to apply after the individual has left the firm.
Clearly, there seems to be a recognition that the existing compensation mechanisms tend to incentivize short-term returns rather than long-term performance. It is interesting to see how developed markets are shifting from unhindered compensation packages (as a means of incentivizing top management) toward a more restrained policy. The announcement by the U.S. President last week to set “new rules for companies receiving “exceptional assistance” from the government [that] include a $ 500,000 cap on salaries for senior executives (compensation beyond that must be in restricted stock), expanded bans on golden parachutes, and increases to “clawback” provisions” is consistent with this broad approach.

To end with a comparison on executive compensation regimes, these new restraints on pay packages in the U.S. are moving that regime closer to the Indian set up where executive compensation has always been subject to caps. For the Indian position, please see an earlier post, the relevant parts of which are set out below:
“The remuneration of directors and senior managers in Indian companies are not comparable to the kind of stratospheric proportions witnessed in the U.S., although Indian pay-scales at the top echelons have seen a steady increase over the years. However, one key difference in India (at least in theory) is that senior management’s pay is subject to shareholders’ approval and also to certain maximum limits in view of Sections 309 and 198 of the Companies Act, 1956. To that extent, shareholders do have a “say on pay” that is mandated by law, unlike in other markets (such as the U.S.) where the decision is largely left in the hands of the boards of directors or their compensation committees.”

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