Saturday, February 04, 2006

10 commandments: Systemic Risk

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my 10 commandments on systemic risk

I watched John Thain's address today and was struck with some stuff he spoke about on regulation issues. The fact that the equities and the cash markets are regulated separately- this to me sounds like good and bad for it has the makings of for and against a systemic crisis...

The securities market, unlike banks, has been less susceptible to contagious transmission of shock. Policy discussions should explicitly worry about the once-in-a-few-years events where market integrity is tested.
The design of regulatory mechanisms based only on individual bank risk could be suboptimal in a multiple bank /Universal Bank context, and may well have the unintended effect of accentuating systemic risk. Optimal regulation should be collective in nature and should involve the joint failure risk of banks as well as their individual failure risk. The Lord appeared to me in a dream last night and told me that tthe challenges facing our financial markets for the next 2 years are :
Issue 1: Protecting institutional investors:
Institutional investors, increasingly large participants in Hedge Funds and proprietary money management firms should be given additional rights to compel management to disclose more relevant data, value at risk as well as more specific information on risk return profiles. Government should encourage the development of rating agencies to examine and rate large Hedge Funds with high institutional investments in them. It is particularly important that managers of investment firms give extensive information and are closely supervised. SEC ought to bring these firms within the ambit of regulation.I see some development happening here and this is good.
Issue 2: Strengthening takeover regulation:
Minority shareholders have begun to play an increasing part in the post bubble economy. Regulation should be strengthened to protect minority shareholders and further protect exploitation by majority holders. Lack of minority shareholder protection severely restricts the ability of firms to raise capital. Legal changes are needed to strengthen protection and take over codes. This issue is pretty bad in emerging markets and with the markets being increasingly integrated i worry..
Issue 3: Fall in efficiency given the fast pace of innovation:
Regulation needs to be strengthened to improve the informational efficiency of markets through better disclosure and price signaling mechanisms. The ban on insider trading should be reexamined of there is a case that insider trading improves overall market efficiency but must be balanced against its costs (benefiting at the expense of the uninformed and this reduces the willingness of uninformed investors to participate). Given the increasing esoteric nature of newly designed securities instruments manipulation will potentially cause significant misallocation of resources. A lack of confidence in the transparency of the securities market will reduce the total amount of investment that is undertaken. Specific steps that help to strengthen the aforesaid and improve market efficiency is absolutely critical to counter the effects of financial innovation.
Issue 4 : Risks posed by asset volatility:
In order to reveal information, prices have to fluctuate with changes in underlying information; but price fluctuations themselves are costly to the extent that they impose risk of uninsured changes in wealth on investors. There is therefore a trade-off between allocative efficiency and risk sharing. Asset volatility has been very high in some markets . While regulation should not interfere in free market functioning there is need to ensure that the securities markets are not out of synch with those for indexed products and derivatives. Regulation for integrative management of these linked instruments should be enacted to be more effective.
Issue 5: Intra Bank Risk:
Securities Regulation has traditionally placed a very limited emphasis on the prevention of systemic risk since most of the regulation is towards regulation of the individual firm itself. Additional regulation needs to be passed to ensure that securities firms continue to segregate customer funds from the firms’ own funds and disclose leverage in proprietary trading strategies. There is a risk that Banks will fund in-house securities business and separate regulators will lack an integrated picture of the firm's consolidated position. Regulation aiming to create Chinese walls will make it easier that when a securities firm fails, it will be easy to transfer the assets of that firm to another firm .Security firms have access to large value payment systems and there is need to beef up regulation of the clearing corporation.
Issue 6 : Internationalization:
Leading securities firms have become increasingly international. They operate through a complex structure of affiliates in many different countries with differing bankruptcy regimes. The effect of international bankruptcy laws on the fate of a domestic securities form needs to be studied. Cases such as the collapse of Barings Bank, BCCI and others are examples of what has happened in the past. Regulation then needs to be enacted to respond to the risks of international bankruptcy.
Issue 7:Growth in size:
Securities firms and banks have consolidated to form larger and larger entities. Partly this is because the formation of financial conglomerates has often involved mergers and acquisitions. Although it is possible that larger financial firms will be less likely to fail, the occurrence of failure is more likely to be associated with systemic risk since the spillover effects on the rest of the financial system are bound to be greater. New Regulation should be enacted that treats the largest firms differently from the small securities firms.
Issue 8: Over-the-counter derivatives:
The growth in the OTC market as well as the concentration of activity in a few large firms brings corresponding increasing concentration of risk. They pose risks to the system through a combination of size and market illiquidity. Capping the size of financial entities through regulation would help address the first, improving market liquidity would address the next. OTC derivatives markets span national borders and are subject to a wide range of regulatory regimes. Such firms are likely to be managed in an integrated fashion along lines of business without regard for legal entities, national borders, or functional regulatory domains and with substantial intra-group transactions that would be difficult to disentangle in a crisis. Although the laws that govern bankruptcy procedures correspond to the legal entity or the regulated entity, these may no longer correspond to coherent part of the global firm. There is need to encourage the intrinsic strengths of exchange-traded derivatives when compared with off-exchange derivatives and these should be regulated more.
Issue 9: Bankruptcy laws for derivatives transactions:
The ability to closeout all derivatives contracts with the failed firm, net them and liquidate the collateral eliminates the degradation of collateral that could occur during lengthy bankruptcy procedures and enables counterparties to settle other transactions that may have been linked to the positions with the failed firm. When a failed firm such as LTCM has taken positions that are large enough to move Prices, however, these procedures may disrupt markets and exacerbate losses to counterparties and other investors with positions similar to those of the failed firm. In such cases, the simultaneous closing out the failed firms positions and attempts to liquidate illiquid collateral could cause the market to crash directly causing losses to the counterparties and other investors with similar positions. This could lead to additional defaults and additional pressure on illiquid markets as additional collateral is liquidated. The benefits of the current derivatives laws for securities need to be reexamined given the potential for systematic risks
Systems are only tested in times of market volatility; short track--records of functioning under normal conditions should not generate confidence. The best designed regulatory framework will fail to generate safety if it is not backed by effective enforcement and there is need to beef up enforcement in the next two years.
Issue 10: ???? I bet this one's gonna take us down:(( What is the 10th commandment??:(( Anyone knows??


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