Henry Kaufman in second WSJ commentary, calling for fundamental bank regulatory reform

Henry Kaufman follows up with a second powerful opinion piece in the Wall Street Journal on the question of bank regulation and monitoring. Who's Watching the Big Banks? Tuesday, November 13, 2007.

Kaufman follows up on his earlier article analyzing the inability of the Fed's regulatory system to monitor and regulate risks taken on by the largest banks, which carry vast moral hazard because they are deemed too big to fail, and which then bury th risks in exceedingly opaque financial instruments which are, one might say, as good at spreading risk as they are at concealing it and which leave no one with sufficient knowledge or incentive to discipline it. In this article he goes forward and proposes a radical regulatory solution. Excerpts:

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November 13, 2007
COMMENTARY

Who's Watching the Big Banks?

By HENRY KAUFMAN

November 13, 2007; Page A25
WSJ

Another credit bubble has met its demise in U.S. financial markets. This time the spotlight is centered on the subprime mortgage market, although the slowing economy is likely to unmask other weak sectors in the credit markets. We might happily avoid a business recession, yet compared with the robust economic expansion of recent years the correction might seem like a recession nonetheless. Meanwhile, it's worth asking who is in charge of our financial system during this critical period? That is, what kind of role should regulators play to ease us through the crisis and safeguard against future turmoil?

Up to now, only two measures for stabilizing and strengthening financial markets have gained serious attention. The first is a proposal put forth by the Treasury Department that leading U.S. financial institutions set up a "superfund" called the Master Liquidity Enhancement conduit. This fund would buy mortgage securities from the structured investment vehicles (SIVs) that had invested in subprime mortgages.

Such a superfund is neither needed nor likely to work. To begin with, the banks involved in the subprime predicament still hold the capacity to meet their lending commitments. In addition, the proposed superfund would acquire only the better quality mortgages of the SIVs. That hardly would encourage the remaining commercial-paper holders of the SIVs to roll over their paper. Indeed, it seems the basic purpose of the superfund is to delay the accurate pricing of the junk mortgages in the SIVs, and to delay the recognition of losses. The superfund would neither resolve nor mitigate the fundamental problems in the financial markets.

The second measure to mitigate the financial contraction is, of course, the Federal Reserve's aggressive easing of monetary policy. The Fed has lowered both the discount and federal-funds rates, while also injecting a large volume of reserves into the banking system. The central bank went even further by informing member banks that credit would be readily available at the discount window, thereby signaling its help for banking in meeting their commitments -- including SIV demands on their credit lines.

On the global stage, major central banks in Europe have served up a huge new volume of reserves to mitigate stresses in their banking systems. Even the Bank of Japan, which had hinted it would raise money rates, seems to have pitched in by abstaining from rate hikes.

Yet in spite of these efforts on the part of monetary officials in the U.S. and world-wide, market confidence remains shaky. The volume of transactions in the subprime mortgage market is tepid at best. Stock prices of financial institutions have fallen sharply. In most markets, volatility is high. Key commodities prices have risen sharply. The U.S. dollar is under attack.

The problem is that the Federal Reserve and Treasury have failed to come forth with solutions that will limit future financial excesses. They've also failed to keep pace with a series of fundamental structural changes that have transformed markets in recent decades. As a result, in an age when "transparency" is the business watchword, financial markets have become increasingly opaque. This in turn has fostered doubts and fears about the underlying strength of markets and their institutions. Compared with a generation or even a decade ago, financial markets today are much more complex, an order of magnitude larger, and filigreed with new and often arcane credit instruments. Risk taking -- driven by the mystique of quantitative risk modeling -- has become more aggressive. And these structural changes, many of which were initiated in the U.S., are rapidly gaining acceptance in other major financial centers around the globe.

This new, highly securitized financial regime can work well only if securities are priced accurately. Stated differently, weaknesses and failures in securities pricing are wreaking havoc in financial markets. Traders and investors are learning the hard way that not all assets are the same when it comes to pricing. There is a sharp difference between marking-to-market U.S. government securities or large high-quality private-sector issues versus lower quality issues for which pricing is done off a model or matrix.

This brings to mind Fed Chairman Ben Bernanke's response when I asked him at last month's Economic Club dinner in New York what information he would like that is not currently available to him. Pointing immediately to the problem of pricing subprime instruments, Mr. Bernanke said frankly, "I would like to know what those damn things are worth." Then added, "This episode has revealed a weakness in structured credit products."

Giant financial conglomerates contribute to the opaqueness in our financial markets. Their activities span across many sectors -- from consumers to business, from trading to investing, from securities underwriting to lending and proprietary trading, from insurance underwriting to real-estate brokerage, from managing billions of dollars of other people's money to consulting and advising. Their global presence has been growing briskly, with some now garnering more than half their profits from foreign operations. Their size, scope, and embeddedness in financial markets are impossible to decipher from their published balance sheets. Because their reach is so vast and deep, these financial behemoths are deemed too big to fail.

In the wake of these profound structural changes in our financial system, who or what can provide oversight and supervision? Today's regulatory system -- though system is too strong a word -- is largely a historical artifact left over from the era when financial markets and institutions were much more fragmented and insulated from one another. In the U.S., state and federal regulators of various kinds continue to oversee specific activities in the financial markets and institutions. But the destruction of financial silos that once separated brokerage, commercial banking, investment banking, insurance, mutual funds, and other financial businesses has made fragmented state and federal regulation obsolete.

The Federal Reserve System comes closest to performing the role of financial system guardian. Its central mission is to implement policy that will encourage sustained economic growth. But its monetary tactics are asymmetrical. Leading Fed officials periodically acknowledge that the central bank knows what to do when a financial bubble bursts (ease monetary policy), yet it lacks the analytical capacity to identify a credit bubble in the making. ....

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What is urgently needed is a new kind of institution that I will provisionally call the Federal Financial Oversight Authority. This regulatory body would oversee only the largest U.S.-based financial institutions -- the giant conglomerates engaged in a broad range of on- and off-balance-sheet activities that I noted above. The new authority would monitor and supervise these huge financial conglomerates -- assessing the adequacy of their capital, the soundness of their trading practices, their vulnerability to conflicts of interest, and other measures of their stability and competitiveness.

I am not proposing comprehensive supervision of most or all financial institutions. Oversight of the 10 to 20 largest financial conglomerates would fill the much-needed regulatory void, given the vast reach of those dominant players. The 15 largest institutions in the U.S., for example, have combined assets of $13 trillion. They dominate many key areas of trading, underwriting, and investment management. Many command an overwhelming position in derivatives and in many of the esoteric financial instruments that have grown so rapidly in the past decade.

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Mr. Kaufman is president of Henry Kaufman & Company Inc., an economic and financial consulting firm, and author of "On Money and Markets: A Wall Street Memoir" (McGraw-Hill, 2001).

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