COP Special Report on Regulatory Reform

The Congressional Oversight Panel has discovered youtube and you should too. Below is a video of Elizabeth Warren explaining, in layman's terms, the need and recommendations for Financial Regulatory Reform.

At the moment of discovery, this video had only 7 views.

Don't ya all think something as critical as looking at the reasons the world is in a global financial collapse with job losses, lost homes, lost retirement, personal tragedy, suffering and pain deserves at least 5 minutes of your time?

The video accompanies The Congressional Oversight Panel released a report on January 29, 2009: Modernizing the American Financial Regulatory System. This is a Special Report on Regulatory Reform required under Section 125(b)(2) of Title I of the Emergency Economic Stabilization Act of 2008; Pub.L.-110-343.

The COP website is loaded with reports, hearings, testimony and they also have a blog. Today they released the Special Report on Regulatory Reform (1/29/09, large pdf).

Here's The Bomb:

Had regulators given adequate attention to even one of the three key areas of risk management, transparency and fairness, we might have averted the worst aspects of the current crisis.

  1. Risk management should have been addressed through better oversight of systemic risks. If companies that are now deemed too big to fail had been better regulated, either to diminish their systemic impact or to curtail the risks they took, then these companies could have been allowed to fail or to reorganize without taxpayer bailouts. The creation of any new implicit government guarantee of high-risk business activities could have been avoided.
  2. Transparency should have been addressed though better, more accurate credit ratings. If companies issuing high-risk credit instruments had not been able to obtain AAA ratings from the private credit rating agencies, then pension funds, financial institutions, state and local municipalities, and others that relied on those ratings would not have been misled into making dangerous investments.
  3. Fairness should have been addressed though better regulation of consumer financial products. If the excesses in mortgage lending had been curbed by even the most minimal
    consumer protection laws, the loans that were fed into the mortgage backed securities would have been choked off at the source, and there would have been no toxic assets to threaten the global economy.

Ok, that's pretty damning and good for COP. But what about the solution?

Here are the areas for reform

  1. Identify and regulate financial institutions that pose systemic risk.
  2. Limit excessive leverage in American financial institutions.
  3. Increase supervision of the shadow financial system.
  4. Create a new system for federal and state regulation of mortgages and other consumer credit products.
  5. Create executive pay structures that discourage excessive risk taking.
  6. Reform the credit rating system.
  7. Make establishing a global financial regulatory floor a U.S. diplomatic priority.
  8. Plan for the next crisis.

They also have summaries: part I and part II.

One immediately disturbing fact in this summary is Senator Charles Schumer used the McKinsey Institute for research. The McKinsey institute has a vested business interest in offshore outsourcing and has produced fatally flawed reports, based on inaccurate assumptions in the past.

Now going through the report and onto Action items or some of the high level details of what should happen next, these statements popped out upon first read:

7. Make Establishing a Global Financial Regulatory Floor a U.S. Diplomatic Priority

Problem with current system: The globalization of financial markets encourages countries to compete to attract foreign capital by offering increasingly permissive regulatory laws that increase market risk.

So, beyond workers wages being repressed due to globalization, this statement implies the same truth with financial markets.
Yet, is the answer to make financial systems a Diplomatic Priority? It seems to me in the history of the international trade and finance of the last 30 years, the United States likes to trade away the farm for some nebulous policy promise that does not even come close to negating whatever they threw away (say our United States Manufacturing sector as an example).

The report really blasts the credit rating agencies, which to amplify, remember this CNBC video and reports?

Here is another bomb:

5. Create Executive Pay Structures that Discourage Excessive Risk Taking Problem with current system: Executive pay packages incentivize excessive risk. (p. 37)

Finally, finally, finally a report acknowledging that executive compensation encourages very short term and very stupid financial and strategic moves simply to line said executive calling the shots....pockets.

Oh we love you COPs for this one!

Other recommendations are to stop the Federal laws from invalidating state consumer protection laws and creation of a strong federal and state consumer protection regulatory system, including mortgages.

On derivatives the report suggests a global clearing house and transparency. I believe this needs to go much further. Some of these derivative models are black box mystery. Thus transparency should also be on the derivative mathematical models themselves. Hey, if your CFO can't understand WTF something probably shouldn't be selling it as a new shiny investment vehicle.

For example, they mention modernization of the shadow banking system. How about kill the entire shadow banking system and simply do not allow any such "run around" of the financial regulatory bodies to happen. I am sure we will hear about how to pull a massive shadow financial system out of the shadows by economists and experts such as Roubini, so stay tuned.

There are other action items such as limit excessive leverage, reform corporate chapter 11 banruptcy laws and much on increased regulation.

Now here I am sure is where the real devil will reside, in regulatory details which only mystics and financial institution geeks can even remotely start to comprehend.

For example, this action item,

Action item: Build alliances with foreign partners to create a global financial regulatory floor.

is an alarming statement, depending upon how the details are determined. It's alarming in terms of US law, sovereignty and domestic business law. So far the United States likes to give away the farm, especially to multinational corporate interests where the host country of incorporation is some mere convenience. If we have multinational corporate interests involved in regulation on a global scale, even influencing other foreign nations....well, here come the MNC feudal lords, supplanting domestic governments and economies. (this is my fear and not unfounded considering our history of trade policy).

The summary of COPs action item recommendation list:

  1. Systemic risk is often not identified or regulated until crisis is imminent.
  2. Many financial institutions carry dangerous amounts of leverage.
  3. The unregulated shadow financial system is a source of significant systemic risk.
  4. Ineffective regulation of mortgages and other consumer credit products produces unfair, and often abusive, treatment of consumers, but also creates risks for lending institutions and the financial system.
  5. Executive pay packages incentivize excessive risk.
  6. The credit rating system is ineffective and plagued with conflicts of interest.
  7. The globalization of financial markets encourages countries to compete to attract foreign capital by offering increasingly permissive regulatory laws that increase market risk.
  8. Participants, observers, and regulators neither predicted nor developed contingency plans to address the current crisis.

Also the GAO has issued a report with summary points on the various problems in the financial system as well as recommendations.

There is one most important recommendation point that I think is a great idea. Recommended is advanced mathematical modeling of global financial systems, simulations of stressor conditions, what is economic scenarios to prepare, adapt, to prevent, any future economic Armageddon. Yes, yes, yes it is so critical for our government to start increasing their raw analysis, data points, statistics on what is going on in the United States economy, financial system, including real time applying modern econometrics is long overdue.

Myself, I like the analogy of complex economic modeling to war games and I am sure some of the technology behind such modeling is similar. I just wanna know will they have all of the virtualization goggles, headsets/microphones and tactile gear when they simulate various economic Armageddon scenarios?

Yeah, I can pull out the real meat of what is important in the biggest global financial system overhaul in 60 years...
is there a joystick with that economic simulator?

Good job COP!