What has the Credit Crisis Taught Us?

The FT asks a question:

A fundamental question therefore arises: is the financial system broken, corrupt and in need of reform; or is the system sound, yet subject to external pressures, notably heavy monetary stimulation, with which it could not easily cope?

Roger Ehrenberg has an answer:

Is the financial system somewhat broken and in need of reform? Absolutely. But is the increasingly liberalized system in place today an essential element of a healthy, integrated and global financial marketplace? I think the answer is also a resounding yes. So where have things broken down, and what can we do to fix them? Here are some ideas:
1. Increase transparency among regulated institutions
2. Homogenize global accounting standards
3. Homogenize global regulatory frameworks
4. Aggressively strip conflicts of interest out of the system
5. Clarify the roles and responsibilities of fiduciaries
6. Develop common sense compensation policies and practices

Let's examine these one by one.

1. Increase transparency among regulated institutions
Accounting disclosure of derivatives is pretty much useless. Even with Basel 2 the disclosures on market risk in general are only marginally more useful: the VAR typically tells you little. We need more useful disclosure on market risk, liquidity risk, off balance sheet risk and credit risk mitigation.

2. Homogenize global accounting standards
I don't see this as pressing. Standards are coming together already and while significant differences remain, they are not nearly as important as the things you get no information about from financial statements. See 1. above.

3. Homogenize global regulatory frameworks
Yes, but the issues are mostly not between banks in different countries but rather between banks and non-banks in the same country, notably between banks and insurers but also between banks and broker/dealers. The monolines would never have been able to get into their current state if they had been regulated under Basel 2.

We also desperately need to fix the market risk capital regime. I have talked about this before so I won't go over old ground: suffice it to say, VAR is no longer a useful measure of market risk capital (if it ever was).

4. Aggressively strip conflicts of interest out of the system
This is definitely right. Legal and regulatory steps to align interests are necessary as clearly the buyers of securities either couldn't or wouldn't do the job.

5. Clarify the roles and responsibilities of fiduciaries
What Ehrenberg means is that if you give your cash to someone with the mandate to manage it conservatively and preserve capital, and they buy a Libor + 40 AAA floater that subsequently defaults, you should have someone you can sue. Certainly the idea that a rating substitutes for due diligence is bizarre and it should not be defensible in court. But right now it probably is.

6. Develop common sense compensation policies and practices
This is just a variant of 4. The way people are paid should not set up a conflict of interest between shareholders and the risk takers they pay, nor between those risk takers and the broader financial system.

Conclusion
I do not believe that the credit crunch was brought about chiefly by malevolence or bad faith. Of course there was some of that, but mostly it was a series of small incentive structures combining to produce a systemically disastrous result. Hence we need to fix the rules of the game to produce better incentives.