Excessive Risk Taking

There is no doubt that the current global financial crisis is a result of excessive risk taking in financial markets. Banks took much risk and investors were led to buy complex financial products, whose riskiness was not well understood. Existing regulatory and supervisory institutions have failed to keep pace with the growth of financial engineering that lead to complex products. Moreover, credit rating agencies have failed to detect financial excesses that first appeared in the US sub-prime mortgage market in 2007 and later spread to global markets. It was perplexing that many highly rated mortgage bonds plummeted in value precipitating the financial crisis.

Thus it is no wonder that the crisis has triggered calls from all corners for more financial regulation. However, excessive financial regulation has its own downside, namely, by stifling entrepreneurial innovation and reducing efficient risk allocation.

The challenge is therefore to find the right middle ground, where society allows healthy individual risk-taking but makes sure that individual risk does not turn into dangerous systemic risk. The solution should lie on having better regulation, not necessarily more regulation, based on effective supervisory institutions as well as transparency in financial market contracts. The solutions presented below deal with the most pressing issues.

  • Capital requirement for banks. There is already regulation in place on banks’ capital (as in the risk sensitive bank capital proposed under Basel II). However, the existing rules strictly enforce capital requirements, irrespective of economic conditions (the business cycle). This can be counterproductive because it induces bank lending to be pro-cyclical (banks are forced adjust lending in order to maintain their capital base). A solution could be to allow orderly adjustment of bank assets and liabilities when realized losses reduce their equity capital. This solution also prevents fire sales of bank assets, an action that could lead to higher risks of insolvency, especially when many banks try to recapitalize simultaneously. There would still be a role for supervisory intervention before the onset of insolvency and bankruptcy. Finally, capital adequacy ratios should not be based solely on internal bank models, as is the case currently. Judgments about reasonable level of capital should be related in part to market benchmarks (best practices).
  • Strengthening of credit ratings. Credit ratings are influential in investors’ portfolio decisions. Under current practices, a rating agency is paid by the debt issuer, rather than debt buyers, and this raises a possible conflict of interest since the rating agency is typically paid only if the debt is successfully issued. Due to the free rider problem debt buyers have no incentive to monitor the agencies. This means that regulators must ensure proper monitoring of the conflicts of interest inherent in the current rating practice. For instance, supervisory bodies could require rating agencies to give more information about their rating methods.
    Rating agencies should provide just ratings, not any other products or services, including financial advice.
  • Stock trading. Short-selling based on economic fundamentals can be useful for correcting overvalued stocks. However, at times short selling may be a destabilizing force by driving down stocks of otherwise healthy companies. One solution is to reinstate rules that regulate short-selling of stocks (such as the up tick rule in the US, which was abolished in 2007). The up tick rule allows short sales only when the last sale price was higher than the previous price.
    Another solution is disclosure of short selling positions so as to properly uncover possible illegal market manipulation or speculative elements in these transactions.
  • Regulating hedge funds. The hedge fund industry has become an important player in financial markets, including securities, currencies and derivatives. However, the industry has so far been subject to minor or no regulation. To begin with, therefore, hedge funds should be registered and disclose regular and timely information about both their asset positions (especially their asset concentration) and leverage levels. Such information is needed to assess systemic risks posed by complex financial transactions. Prudent regulation of banks could also curb any excesses in hedge funds risk taking, as banks usually provide hedge funds subsidized financing through mechanisms such as prime brokerage.
  • Transparency and confidentiality. The current financial crisis raises the question of transparency and confidentiality in the financial markets regarding different financial institutions. More transparency is needed in terms of explaining what risks are to what extend involved and does the taking of those risks potentially harm the regular – in the sense of basic – banking sector. Here one has to distinguish between the well-established “basic” banking transactions and modern strategies based on financial innovation, which are mostly extremely difficult to understand and difficult to regulate at all. Another approach to establish better transparency would be that banks and other financial corporations report directly to the public instead of to their regulators. The public and the banks themselves could then distinguish between good and bad and banks which are exposed to financial disturbances. Moreover, the onus of transparency would induce managements of financial corporations to behave more cautiously. This leads to another important issue that has to be accounted for, namely the distinction between commercial and the investment banking sector.
  • Commercial vs. investment banking. One solution to overcome inefficiencies of over-regulation in the banking sector goes back to the Glass-Steagall Act of 1933 which was adopted by President Roosevelt but repealed by the US congress in 1999. The idea is to split commercial and investment banks into a two sector banking system and impose different regulatory laws. A kind of two-tier financial system could be established. Commercial Banks are then restricted to operate in “normal” banking business such as taking bank deposits and issuing loans. These banks would be highly regulated in order to prevent that financial shocks spill over to the normal lending and deposit business of the real economy. Investment banks would have the freedom to take more risk and conduct trading relatively free of regulation. The solution would allow commercial banks to continue to underwrite securities and provide merger advice, activities historically handed by investment banks.

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