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Managing Systemic Risk in the Financial Sector

Managing Systemic Risk in the Financial Sector

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Published by Lyle Brecht
Rescuing the nation’s financial system consists of four coordinated and linked restructuring actions: (1) reforming the Federal Reserve System, (2) providing liquidity to sound financial institutions, (3) nationalizing failing and zombie banks, and (4) reforming individual firm regulatory oversight along with adding new regulatory infrastructure capable of monitoring systemic risk to the economy.
Rescuing the nation’s financial system consists of four coordinated and linked restructuring actions: (1) reforming the Federal Reserve System, (2) providing liquidity to sound financial institutions, (3) nationalizing failing and zombie banks, and (4) reforming individual firm regulatory oversight along with adding new regulatory infrastructure capable of monitoring systemic risk to the economy.

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Published by: Lyle Brecht on Feb 19, 2009
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10/02/2010

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I don’t think this is just a financial panic; I believe that it represents the failure of a whole model of banking, of an overgrown financial sector that did more harm than good. 1

RESTORING THE NATION’S FINANCIAL SYSTEM Restoring the nation’s financial system to long-term sustainability consists of four coordinated and linked restructuring actions: (1) reforming the Federal Reserve System, (2) providing liquidity to sound financial institutions, (3) continuing to nationalizing failing and zombie banks, and (4) reforming individual firm regulatory oversight along with adding new regulatory infrastructure capable of monitoring systemic risk to the economy. 2 REFORMING THE FEDERAL RESERVE SYSTEM The Federal Reserve shall set balance sheet Reserves requirements for all financial institutions and intermediaries in the U.S. that provide credit to markets (e.g. commercial banks, insurance companies, mutual funds, and nonbank financial firms and funds that disburse credit in the shadow banking system such as hedge funds and private equity firms, etc. whether onshore or offshore if they do business in the U.S. or hold funds either directly or indirectly from U.S. investors); The Federal Reserve shall no longer accept financial institutions using capital instead of reserves for ensuring the safety and soundness of their institution; The Federal Reserve shall henceforth provide complete transparency as to open market and other transactions it has with individual financial institutions beginning June 1, 2007 and continuing thereafter. Transaction information must be published on the Federal Reserve web site within 24 hours of the transaction occurring. PROVIDING LIQUIDITY TO SOUND INSTITUTIONS The Federal Reserve shall establish interest-free Liability Reserves with financial institutions by purchasing sound financial instruments from credit making financial institutions. A Repurchase Agreement between the Fed and the financial insti-

1 2

Paul Krugman, “The Market Mystique,” The New York Times (March 26, 2009)

“In a financial panic, the government must respond with both speed and overwhelming force. The root problem is uncertainty—in our case, uncertainty about whether the major banks have sufficient assets to cover their liabilities. Half measures combined with wishful thinking and a wait-and-see attitude cannot overcome this uncertainty.” See See Simon Johnson, “The Quiet Coup,” The Atlantic (May 2009).

LYLE A. BRECHT

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tution would set a date by which the financial institution must buy back what it sold to the Fed at the same price it was sold to the Fed; 3 This arrangement for creating liquidity would apply only to financial institutions that pass the U.S. Department of Treasury’s periodic Stress Test requirements for individual firm solvency. NATIONALIZATION OF FAILING & ZOMBIE INSTITUTIONS4 Financial institutions that fail Treasury’s Stress Test and are ineligible to establish Liability Reserves with the Federal Reserve Bank shall decide if they wish to join the National Reconstruction Bank (NRB). Financial institutions who join the NRB shall be subject to the following terms and conditions: One hundred percent (100%) of the outstanding common shares of the bank shall be tendered to NRB at thirty-five percent (35%) of the market price for shares on January 2, 2009 or the date of joining the NRB, whichever is less. All preferred shares will be converted to common stock and be included in the tendering requirements. All outstanding warrants and unexercised stock options as of January 1, 2009 shall be void; NRB shall have sole discretion to appoint boards of directors of member banks; Executive compensation during the recapitalization payback period5 shall be limited to total maximum compensation of $500,000 per annum (in 2009 dollars);6 For banks not choosing to join NRB that go bankrupt or are not able to meet their reserve requirements as set by the Federal Reserve Bank at any time during the next five years: an automatic clawback and mandatory disgorgement provision goes into effect whereby all executives and related parties who received more than $1,250,000 in total compensation during the five years prior to the bankruptcy or noncompliance event shall immediately owe all proceeds exceeding this amount to the NRB;
See Jane D’Arista, “Setting an Agenda for Monetary Reform” (January 2009), Political Economy Research Institute, Working Paper #190.
3

Zombies are financial institutions that only remain open for business by the provision of federal loans, bailouts, guarantees, and/or tax relief.
4

The recapitalization period shall continue until retained earnings from operations are sufficient to repurchase all NRB held shares of the bank at the then current market price. No dividends shall be paid to common or preferred shareholders during the recapitalization period.
5 6

Adjusted yearly for purchasing power parity that includes salary, stock options, and benefits.

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Any person not in compliance within 20 days of notification or who contests this provision shall owe the overage amount and a penalty amount, not-toexceed 120% of the amount owed; Banks may choose to leave NRB affiliation at any time 180 days after their balance sheets meet all regulatory requirements. Once a bank chooses to leave NRB, it may not return sooner than 24 months from the effective date of leaving; NRB, in its sole discretion will determine the timing for selling its common stock ownership in each bank choosing to join NRB, but in any case shall sell its shares in the public capital markets within 10-years of the date at which the bank leaves the protection of NRB; The option to join NRB is open for 90 days from the initial offering date. Thereafter, any bank wishing to join NRB shall not be able to join until after 360 days from the initial offering date has expired; The U.S. Treasury shall inject reserves, subject to its discretion. REFORMING REGULATORY OVERSIGHT Reserves and other solvency, ratings, compensation, and securitization regulations must apply to all credit-making firms making up the financial industry accepting savings from U.S. citizens. including off-shore hedge funds, private equity forms, and other financial intermediaries whose insolvency or sale of risky securities could endanger the U.S. economy or that of other world allies of the U. S.; The sale of securities whose market category exceeds a certain amount ($X billions) should be required by law to occur only through public markets, with OTC transactions and any side agreement deemed unlawful and unenforceable; Establish a fusion center within the U.S. Treasury, the Financial Health Intelligence Center, whose mission is to: (a) analyze technology innovation and labor and capital reallocation needs for the U.S. economy; and (b) recommend proactive changes to regulatory policy, oversight, and enforcement for financial markets based on this analysis. These recommendations would then be forwarded to the regulatory agencies and to Congress, as necessary, for action; Implement a Market Assurance System within the U.S. Treasury that addresses the entire financial industry being regulated.7 This system would automatically sort through firms’ financial data and enable the appropriate regulators to identify financial firms who are misleading investors before such companies become

7

A description of the system is at http://www.scribd.com/doc/9790231/.

LYLE A. BRECHT

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insolvent and before malfeasance becomes known, as a means to restore public confidence in the financial markets; Implement Cost Adjustment Surcharge market re-pricing mechanism within the U.S. Department of Agriculture’s Office of Ecosystem Services and Markets. These surcharges would apply for certain inputs and outputs of the economy where market mispricing discourages timely technological innovation, slows down technology adoption cycles, and inhibits the reallocation of labor and capital by the financial sector to those productive sectors of the economy, thus putting the entire U.S. economy at a competitive disadvantage; Prohibit financial industry insiders from staffing any government regulatory office or agency whose net worth is more than $x amount. A financial industry insider shall be someone who has worked for a regulated financial sector firm for more than 5 years. Exclude as tax deductible business expenses any amounts provided by individuals or firms to lobby on behalf of the financial industry; To prohibit for a period of five years the expenditure of any amount of dollars on lobbying by any financial firm accepting loans, loan guarantees, grants, tax relief, or any other financial assistance from the U.S. Treasury or until all financial assistance is repaid in full to the U.S. Treasury and/or the Federal Reserve Bank; Institute a flat tax of three percent (3%) on gross revenues of all financial industry firms doing business in the U.S. until the full cost of the financial industry bailout is recouped by taxpayers; 8 For financial firms that pay their executives collectively more than two percent (2%) of annual free cash flow, add a tax penalty of five percent (5%) on the firm’s gross revenues from financial products and services sold in the United States. 9

The objective of a flat tax on revenues is to get away from multiple sets of books and accounting trickery to achieve dubious profits that are reported to the financial markets (unrealistically high) or to the IRS (unrealistically low).
8

The objective of such a tax differential for companies paying their executives a larger percentage of free cash flow is to get away from executives managing the company and adopting accounting policies for short term executive pay gains rather than the longer-term benefit for all shareholders.
9

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PROPOSITIONS The primary purpose, the mission, of financial institutions is to “direct a nation's savings into the most productive capital investments – those that enhance living standards” for a sustainable future;10 The market ultimately determines whether allocating capital for particular asset investments is sustainable.11 Non-sustainability is typically signaled by sharp discontinuities of asset prices “largely unanticipated by market participants. For, were it otherwise, financial arbitrage would have diverted it;”12 However, as financial institutions grow in size and the system obtains more power and receives ever more preferred treatment from the government, asset bubbles occur that ultimately destroy wealth in a disastrous financial crash;13 The financial industry is rewarded for short-term, transaction-based activity when sustainable, productive capital investing requires long-term thinking and focus;14 The distortion of capital markets by the financial sector has diverted capital from productive investments to the extent that if one removes the phantom GDP contribution of financial institutions, U.S. overall GDP has not grown in real terms

10 11

Alan Greenspan, “We need a better cushion against risk,” Financial Times (26 Mar 2009).

Sustainability results from the timely process of transforming these economic systems undergoing change to systems that are resilient (less susceptible to collapse) when shifting to lower thermodynamic states. Economic systems are sustainable when thermodynamic state shifts do not cause rapid disruptive nonlinearities - abrupt changes of the system to an unanticipated, less-complex state. “Bubbles seem to require prolonged periods of prosperity, damped inflation and low longterm interest rates.... History also demonstrates that underpriced risk – the hallmark of bubbles – can persist for years” (Greenspan).
12

These inefficiencies result in an unstable economic system that is prone to massive corrections; that lurches from crisis to crisis with ever-spiraling costs to taxpayers and that shatters the lives of its victims. Unstable economies may not only be a source for waves of financial crises, but also a source for local resource wars and terrorism as preferred methods for sorting out temporary winners and losers.
13

Technological innovation and the reallocation of capital to more productive purposes are the two pillars for fostering economic growth. What the economy needs for long-term sustainable growth is to make the long-term investment commitments necessary to increase the wealth of the society. See Daron Acemoglu, “The Crisis of 2008: Structural; Lessons for and from Economics’ (January 6, 2009), 8 and Martin Wolf, Fixing Global Finance (Baltimore: The Johns Hopkins University Press, 2008), 20.
14

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for the past 15 years. The U.S economy has been stagnant as capital has not been allocated to productive investments by the financial sector since the 1970s; The financial system’s short term, transaction-based focus severely distorts the allocation of capital to the most productive capital investments needed to grow the economy toward a sustainable future; 15 Besides not allocating capital to the long-term investment commitments necessary to increase the wealth of the society, the financial industry’s riskmanagement discipline is fundamentally flawed. 16 The central premise of this discipline is that “the enlightened self-interest of owners and managers of financial institutions would lead them to maintain a sufficient buffer against insolvency by actively monitoring their firms' capital and risk positions;”17 Adequate regulations, regulatory infrastructure equal to the task, and timely enforcement are necessary for any capital market to work efficiently. However, in the case of the financial industry, inadequate regulations, a regulatory infrastructure not up to the task, and lax enforcement all contributed to the failure to prevent the present financial crisis. The U.S. regulatory structure failed in all respects as a bulwark against the financial industry’s faulty risk-management practices; 18 The best regulatory oversight under the present conception of regulation is still primarily focused on the risk of individual firms becoming insolvent. 19 Presently

For example, “From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically. From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007”(Johnson).
15

The risk management discipline presently used by the financial industry was “developed out of the writings of the University of Chicago's Harry Markowitz in the 1950s” (Greenspan).
16

What Greenspan is saying is that commonly used bank risk metrics like ‘value at risk’ are nonsense. But, so is the Capital Asset Pricing model, DCF analysis, Black-Scholes equation, etc. as none of these financial models adequately accommodate large and sudden changes in asset prices due to systemic risk (ie. uncomputable rare events - Black Swans).
17

What government regulations provide is the enduring trust to make long-term investment commitments necessary to increase the wealth of the society (Wolf, 20).
18

For example, see “Resolution Authority for Systemically Significant Financial Companies Act of 2009.”
19

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envisioned regulatory structure still does not address systemic risk in its full dimensionality. For example, regulatory reforms do not yet adequately address: (1) the existence of “too big to fail” financial institutions that “gives them a highly market-distorting special competitive advantage in pricing their debt and equities;” 20 and (2) even with “capital and collateral requirements and other rules that are preventative and do not require anticipating an uncertain future,” proposed regulatory measures do not recognize that the present risk management measures of the financial industry have proven to be fundamentally flawed to address systemic uncertainty; 21 Any changes to risk management practices, regulations, regulatory infrastructure, and enforcement can still be subverted by the present “political balance of power that gives the financial sector a veto over public policy, even as that sector loses popular support.”22 What is good for Wall Street is definitely not necessarily what is good for Main Street or the sustainability of the U.S. economy longterm. Any measures to correct the structural problems with the financial sector, problems that will only worsen if the financial crisis if not addressed in a timely fashion, are likely to fall far short if financial industry power is not dramatically curbed.

Greenspan. Present regulatory reform measures only provide regulatory control after-thefact, once their insolvency threatens the entire economy.
20

“The problem in the financial sector today is not that a given firm might have enough market share to influence prices; it is that one firm or a small set of interconnected firms, by failing, can bring down the economy” (Johnson).
21

“[O]only decisive government action—exposing the full extent of the financial rot and restoring some set of banks to publicly verifiable health—can cure the financial sector as a whole” (Johnson).
22

LYLE A. BRECHT

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