Statements from the Shadow Financial Regulatory Committee

Author: Bob Eisenbeis, Post Date: December 11, 2008

The Shadow Financial Regulatory Committee is an independent, non-industry watchdog group whose membership consists of economists and lawyers drawn from academic institutions and private organizations who are recognized experts on the financial services industry.  Their common denominator is the belief that financial markets function most efficiently in allocating resources with a minimum degree of government regulation.  The Committee has been in existence since 1986 and meets quarterly to consider developments in the financial system.

At our most recent meeting this past weekend, we published four statements, three of which focus on key issues that have contributed to the current financial crisis. The fourth is an open letter to the new administration, laying out key short- and long-term issues that would need to be addressed in any attempt to resolve the crisis.  What follows is a brief summary of each statement.  It is difficult to do them justice in just a few short paragraphs, so interested readers are encouraged to use the attached link to access the statements themselves,  Particularly important is the Committee’s “Open Letter to President-Elect Obama” on the financial crisis and what his priority concerns should be.

In Statement No. 264, “An Open Letter to President-Elect Obama,” the Committee distinguished among three separate tasks that the new administration will take on:  

1) Managing the current crisis

2) Developing a program for unwinding many of the short-term, ad hoc programs that the current administration has put in place, and

3) Crafting a comprehensive strategy to help shape what the future financial system will look like. 

The Committee identified five priority areas requiring attention and re-evaluation and made suggestions for each, including:

 1) Government policies subsidizing affordable housing:

If housing is to be subsidized, the Committee suggests it  is better to do so through direct grants which are targeted and on budget rather than through indirect subsidies which lead to financial crises and instability.

2) Ways to limit extension of the federal safety–net:

In order to limit the extension of federal guarantees, policies must be developed to restore competition and that clearly define when and under what exigent situations particular markets and institutions will be subject to government interventions. 

3) Competitive policies and actions favoring financial industry consolidation:

A clear lesson from the crisis is that some institutions are now too big to manage, and current rescue policies have fostered further consolidation.

The Committee proposes that the disproportionate systemic risks posed by large complex institutions be recognized and an ex ante systemic risk premium surcharge be levied to internalize the costs that these institutions pose to the financial system.

4) Prudential supervision and regulation of financial institutions and markets:

The Committee also argues that a careful study of the causes of the crisis reveals that there was a significant breakdown in incentives to control risk taking, both within financial institutions and in the regulatory system.

The remedy is not more government regulation but rather policies that efficiently ensure that risks are transparent, recognized, and acted upon by supervisors in a prompt fashion. 

5) Rules ensuring adequate disclosure and transparency in financial transitions and positions: 

Finally, it is clear that policies must be developed that ensure that financial institutions make themselves more transparent to investors, creditors, and counterparties and that regulators can play an important role in this process by ensuring that the information needed by market participants is made available. 

Statement No. 265 focused on the “Regulation of Credit Rating Organizations” and specifically addressed the different approaches being taken by the SEC as compared with the European Commission. 

The Committee expressed concern that the EU approach to enforcing transparency on the Credit Rating Organizations risks Balkanization of world capital markets, because it would permit the establishment of different rating standards in different jurisdictions and impede cross-border comparison of credit worthiness. 

At the same time the Committee points out that the SEC had originally proposed some bold and potentially promising proposals to reform the role of Credit Rating Organizations, including enshrining their ratings in government regulation. 

But the SEC last week chose not to mandate disclosures that would enable outside parties to evaluate the ratings.  It also opted to deal with the potential conflict of interest between ratings and advising by prohibiting the rating of issues that the organization to which they provide advisory services. 

Given industry practice, the Committee questions whether such prohibitions will be practical or enforceable. 

The Committee argues that the best way to reform the process is to simply eliminate ratings from the regulatory process by removing references to ratings from its rules and regulations. 

Statement No. 266 takes another look at “Fair Value Accounting” because the recently enacted Emergency Economic Stabilization Act of 2008 mandates that the SEC investigate the role that mark-to-market accounting rules may have played in the financial crisis.

The Committee argues against suspension of the rules, since this would not in any way address the uncertainty that investors, creditors, or counterparties may have about the quality of the underlying assets on financial institution balance sheets. 

The Committee also notes that the criticism that marking assets to market is pro-cyclical misses the asymmetry that the preferred alternative, historical accounting rules mainly prohibit the writing up of asset values during expansions but, like mark-to-market rules, require assets to be valued at the lower of cost or market when they decline. 

The Committee points out that careful reading of the mark-to-market rules, especially for Level 3 assets for which there are no reliable prices or whose markets are distressed and require judgment, reveals that the existence of prices in distressed markets should be informative but not determinative in valuing assets. 

It recommends that there should be a concerted effort in the case of hard-to-value assets to ensure that there is adequate disclosure of the holdings of such assets, as well as the methods employed in their valuation. 

The Committee’s final Statement No. 267 addresses the fact that “Regulatory Responses to the Current Crisis Have Undermined the Integrity of Tier 1 Capital and Tier 1 Capital Requirements.”  It points out that during the financial crisis institutions that have been recipients of government funds in the form of perpetual preferred stock have been elevated to the level of Tier 1 capital; and a number of hybrid instruments, and even subordinated debt in the case of French institutions, have been authorized by regulators of various countries to be added to Tier 1, weakening the ability of Tier 1 capital to absorb losses.

In addition, recent accounting conventions have contributed to the problem.  For example, Freddie Mac was recently permitted to include $21 billion of fair-value losses on available-for-sale assets in its equity base, reducing its reported leverage from 76 to 1 to 26 to 1.

As a result of these and other problems, Tier 1 capital ratios increasingly have served as unreliable guides in assessing an institution’s capital adequacy, especially during the recent crisis.

It has become increasingly clear that market participants lack confidence in the reported capital ratios and especially risk-related capital ratios and this, in combination with recent research, suggests that increased reliance upon appropriately constructed leverage ratios may be more effective and less pro-cyclical than the current approach to regulating capital adequacy.

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