The FSA Gets It Right

Lord Adair Turner, Chair of the Financial Services Authority (FSA) of Great Britain, is a former non-executive Director of Standard Chartered Bank, former vice-Chair of Merrill Lynch Europe, and a former senior executive at McKinsey & Company. Near to my heart, he studied History and Economics at Gonville & Caius College, Cambridge University. As my musician son would say, "He's got the chops."

As our Financial Crisis Inquiry Commission held its first meeting on September 17th and grinds along, I believe that the March 2009 "Turner Review" from the FSA is an excellent, informative, clearly written one-stop resource on the origins of the crisis and on the market and policy changes needed for the future. It has some very striking charts that bring home the points in sharp relief.

The opening chapter, "What Went Wrong?" should be read and actively discussed in classes and in the board rooms of financial services companies. Lord Turner has become a bit of a controversial figure, which to my mind means that he is getting to the right issues on wholesale financial services.

Summarizing the benefits of securitization, the Review correctly notes that it should: (1) reduce banking system risks; (2) cut the total costs of financial intermediation; (3) pass credit risks on to end investors, thereby freeing banks from holding unnecessary and expensive regulatory capital.

Markets in securitization-related products ballooned during a period of extraordinarily low real interest rates as everyone hunted for yields. So, for example, the credit default swap market stood at $5 trillion in 2H 2004 and soared to almost $60 trillion by 1H 2008. As the markets expanded, relatively little of the securitization production went to end investors, and much of it went to the proprietary trading desks of other banks (see Lehman Brothers et al). The retained tranches were themselves hedged via CDS. Some of the product was repackaged into CDOs and CDO-squareds. Finally, some of the product was used as collateral for short-term bank liquidity. So, the basic premise that created the securitization industry was completely turned upside down.

Repeal of Glass-Steagall again seems like a horrendously bad political and regulatory decision. What it allowed was for trading books at banks to have capital requirements much lower than the capital requirements for the banking books of the parent company. As commercial banks became extensively involved in proprietary trading, when asset prices started collapsing that directly affected parent bank profitability, creating a crisis in confidence and in short-term bank liquidity. Historically, that crisis in confidence could have only occurred from a run on deposits. Now it occurred due to trading activities that were remote from the fundamental commercial bank mission of "maturity transformation."

Think Wall Street knows how to manage risk? Here are two pithy quotes, "At the individual bank level, the classification of these (Structured Investment Vehicles) as off-balance sheet proved inaccurate as a reflection of true economic risk, with liquidity provision commitments and reputational concerns requiring many banks to take the assets on balance sheet as the crisis grew..." There is a breathtaking chart showing the historical leverage ratios of the larger banks, and the charts for UBS and Morgan Stanley are poster children for irresponsible risk management.

Financial innovations (lower tranches of CDOs and CDO-squareds) had "very high and imperfectly understood leverage..." The complete failure of the VAR models have been well-documented by Roubini and others.

According to the Review, "...the development of securitized credit has ended up producing the worst financial crisis for a century." The introductory chapter talks about poor regulation and inadequate capital standards, a message that was recently reiterated by Secretary Geithner in a speech that was not attended by a single money center bank CEO. Again, it must mean he was on to the right issues.

Some basic economic points are well made. Market efficiency does not mean market rationality. Even market efficiency is not something we should take for granted on Wall Street. For example, a chart on bank CDS spreads shows that the market did not anticipate the credit problems ahead. At best, the spreads ranked the relative risks of certain banks (such as Northern Rock in Britain) accurately, but the spreads were a useless leading or even coincident indicator. Neither were the share prices of the banks themselves, and yet stock prices are a big component of US leading economic indicators.

Individual rationality does not sum up to collective rationality. Economic behavior of individuals is not dominated by the "rational maximizer" model that we study in economics and finance.

Finally, Lord Turner starts to stake out some meaningful and controversial ground when the report says that the increases in market efficiency from the creation of complex financial products is essentially trivial. This is a powerful quote that forms the basis for the recent speech Lord Turner gave at Mansion House: "Wholesale financial services, and in particular that element devoted to securitized credit intermediation and the trading of securitized credit instruments, grew to a size unjustified by the value of its services to the real economy." How did this happen? The margins in financial services, and in particular on proprietary trading of these products are opaque. There is substantial knowledge and information asymmetry in the markets. Finally, there are the principal/agent relationships between investors and banks, and between banks and the employees running the trading desks.
This leads to a fundamental economic process called "rent extraction." Trying to regulate compensation does not get at rent extraction fundamentally.

Just a word to the Financial Crisis Inquiry Commission, there's no need to reinvent the wheel. The origins and mechanisms of the crisis have been very well laid out. Let's get right to better regulating markets and the products for the future.