Advocating a Financial Markets Risk Index

| April 3, 2009
April 20009 Topic of the Month

We need to adopt a standards based approach to regulating our financial markets.

In my last post, discussing regulation of global financial services, I promised a modest proposal for change. Below is part 1, just in time, it seems given the outcomes of the G20 summit in London. I am pleased that the summit produced a positive outcome, but I am worried that proposed reforms to global regulation will repeat and entrench the errors of the past.

But first, on a positive note,  I congratulate Timothy Geithner, US Treasury Secretary, for putting forward a systemic approach to risk management in financial regulation. I proposed a systemic approach to regulation in Compliance and Regulation in the International Financial Services Industry, last year. What I have to say here builds on that. The basic assumptions are that we need a new model of regulation, which must transcend national boundaries and that this new model should be based on a standards approach, rather than follow traditional regulatory approaches. Let me explain by way of example.

When a wildfire or a hurricane approaches, people are told of the strength and dimensions of the event and of the likely level of risk they face. Armed with that information, people can make their own choices, to flee or to stay, to stay in the house or to seek shelter somewhere else, and so on. When it comes to fires, the level of sophistication in estimating the likelihood and probable consequences of a fire is very high. There is a Forest Fire Danger Index (FFDI), which is a composite measure of humidity levels, wind speed, temperature, and combustibility of fuel. The FFDI has proven itself to be highly reliable.

April 20009 Topic of the MonthI am proposing that we develop a measure similar to the FFDI for financial markets, with two levels of measurement, for the market as a whole and for significant segments. This measure could be called the Financial Markets Risk Index (FMRI). The FMRI would be a composite of the level of competence of the regulator(s); the level of sophistication of the market's soft and hard infrastructure; the level of deviation of the market from established measures, such as price to earnings ratios, for example; the stability of the host economy; the level of competence of ratings agencies; the medium-term trajectory of the host economy; and the level of sophistication of the host civil society.

The FMRI would be compiled and published by an independent authority that has the necessary competence to produce it, which, in Australia could be the Australian Bureau of Statistics (ABS). The ABS is a creature of Parliament, made independent by statute, and is not subject to directions by government. It is not clear whether such an agency exists in the USA. The US Congress may have to create one and would do well to use the ABS as a model, because it is generally regarded as a global exemplar of best practice. To make the FMRI feel real, let us calculate an illustrative example.

The level of competence of the regulator(s) would be determined by reference to standards adopted globally, let us say against a scale of 1 to 100, where the latter point represents perfection or total compliance. Each year (and perhaps more frequently during times of turmoil), national regulators would be audited by an independent international panel and rated against these standards. When I say competence, I mean the capacity to perform effectively a given function or functions or role-one either can or can't do it; there is no in-between rating.

Let me illustrate my point. Would you use a brain surgeon who is almost capable of performing surgery or trust an airplane pilot who can almost fly an aircraft? I think not. You would not trust your own life or the lives of several hundred to such people.

So, why is it that do we not apply the same logic in the case of people or organisations that control the future of millions or even billions? Why is it that we put our future and our children and grandchildren's future in the hands of people whose competence has never been tested objectively? After all, these are the same people who allowed Bernard Madoff to get away with fraud on a grand scale for decades. These are the same people who have run banks and other financial institutions that have been found sorely wanting.

I say we should stop trusting those who have proven they do not deserve our trust.

Those appointed to be a regulator should be competent to do the job and should be tested regularly, to keep them on their toes. This is why, by the way, I do not support the proposition that we should have some sort of global or trans-national regulatory agency. We would end up with the same sort of people who have fallen well short of the mark every time they have been put to the test, because the same sort of people who have failed in the USA exist elsewhere, for the same reasons. It is a club of those in the know who then pretend to police their fellow members. Allow me to illustrate this, by recounting a story told by Robert Manne, an Australian political commentator, in an essay titled "Neo-Liberal Meltdown".

James Lieber in the Village Voice tells a fascinating story. One of the engine rooms of the derivatives market was the London-based financial-products arm of the (later bailed-out) American insurance giant AIG. In 200, the chief legal officer of AIG asked the head of insurance regulation in New York whether he would like to audit their business. The New York regulator politely declined.

More next week, but, meanwhile, feedback of a critical nature would be welcome and useful.

Patrick Callioni is a former senior public servant, with the Queensland and Australian Governments, and is now the Managing Director of consulting company, Enterprise Intelligence Pty Ltd, which specialises in helping business to do business with government and vice-versa. www.enterpriseintelligence.net.au His book Compliance Regulation and Financial Services is available at Amazon

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  1. MikeM

    April 3, 2009 at 10:21 am

    Poachers as gamekeepers

    James Lieber in the Village Voice tells a fascinating story. […] In 2000, the chief legal officer of AIG asked the head of insurance regulation in New York whether he would like to audit their business. The New York regulator politely declined.

    Whether the New York State Insurance Department would have done anything about the London AIGFP credit default swap business, whether he would have even viewed this stuff as insurance, we cannot know, and the former head of the agency has since died. Lieber points out that at that time AIG was a highly respected blue-chip company with a triple-A rating. (Lieber's article, which is well worth reading, is here.)

    The problem with AIGFP was not solely the age-old problem of sloppy management controls and someone pinching or gambling away money (although as Lieber also tells, the head of AIGFP reportedly rebuffed AIG's internal auditor). The problem was a result of financial innovation in which few were yet clear about the rules. That is similar to the one that caused John Meriwether's Long Term Capital Management (LTCM) hedge fund to blow up in 1998 – even though Meriwether had Nobel Economics Prize laureates, Robert Merton and Myron Scholes who invented modern financial options markets, on his staff (transcript of US Public Broadcasting Service program about the saga here). Nobody expected the financial crisis that started in Thailand in 1997 and spread to much of East Asia, nor that Russia would default on its sovereign bonds in 1998. Especially LTCM.

    Similarly, it is almost certain that nobody at AIGFP expected eruption of the sub-prime housing loan debacle. 

    If you'd asked Warren Buffett about AIGFP's activity though, he would have said that the CDSs were “financial weapons of mass destruction”. If you'd asked Nassim Nicholas Taleb, he would have said, “beware of black swans".

    Peter Fisher said it another way in the program about LTCM:

    The question that I don't yet know the answer to… [is] whether this was a random event or whether this was negligence on theirs and their creditors' parts. If a random bolt of lightning hits you when you're standing in the middle of the field, that feels like a random event. But if your business is to stand in random fields during lightning storms, then you should anticipate, perhaps a little more robustly, the risks you're taking on.

    I'd put Bernie Madoff's exercise in the same category as Nick Leeson's single-handed destruction of Barings Bank. Any competent auditor who'd gone in there should have understood the problem, but apparently none did. LTCM, AIGFP and perhaps even the rating agencies, S&P, Fitch, Moodys: in these sorts of cases you may need former poachers as gamekeepers – gamekeepers who read what the Financial Times does, a couple of years before that excellent newspaper. Last month Henny Sender wrote:

    In retrospect, a glance at AIG’s second quarter 2008 financial statement makes for an interesting read. Buried in that report is a cautionary tale showing just how dangerous credit derivatives can be when combined with insufficient risk management and regulatory oversight – or both sides of these transactions. Unfortunately, few people read the report when it would have been relevant.

    The report fully discloses the $446bn in credit insurance AIG sold. The swaps were written out of AIG Financial Products, a non-bank hidden at the heart of the insurance giant. But because AIG wasn’t regulated as a bank, it wasn’t saddled with any requirements to hold capital against these massive potential liabilities.

    Poachers as gamekeepers….

    MikeM worked for a bank as a database administrator in 1982.