Viewpoint: System Needs an Overhaul, Not Tweaks

Article excerpt

The current financial crisis has solidified the belief among many of the sector's keenest observers that we need to remake the major supports of our financial services infrastructure. Here are some of the pressing issues.

* Who should regulate financial services, and how?

* How should financial firms conduct risk management?

* Is the accounting for financial firms adequate?

* Do the laws and regulations limiting the flows of funds between banking and nonbanking entities need to be modernized?

* When, how, and to whom should we extend the federal safety net?

Extensive evidence supports the belief that fundamental change is needed. There's no denying that the vulnerabilities of our system have been laid bare over the past nine months. The weaknesses of diagnostic and risk mitigation tools have been exposed.

Regulatory breakdown. Many of the world's most astute financial leaders thought last summer that the subprime mortgage disruption was a minor matter involving a relatively small class of homeowners. Harsh reality was obscured by a regulatory system that provided neither transparency for nor oversight of the activities and exposures of the vast majority of counterparties in our financial system.

For example, the regulatory community could not or did not stop pervasive, unsound practices in the mortgage brokerage industry, including fraudulent documentation. Every day it is becoming more apparent that these practices will prove toxic not only for subprime and "alt-A" borrowers, but also for many who have been classified as prime credits.

And we are not talking about the occasional scam. We are talking about millions of borrowers and over $1 trillion of lending.

At the same time, regulated institutions - often engaged in the same businesses as the unregulated financial world - are subject to an omnipresent regime. This enveloping system did not spare them from the mortgage crisis, even though it has subjected them to hundreds of millions of dollars of fines and compliance costs that unregulated institutions hardly have to think about.

Such regulatory imbalance creates many problems. The unregulated industry, at least for a time, can produce better returns on equity than the regulated one, thus attracting capital and pushing the regulated industry out on the risk curve to compete.

Risk management and financial modeling. Despite considerable advances, modern risk management has not proven up to the task. Risk managers and other executives could not measure the extent of risk across their enterprises, or they could not value their positions, or they could not control traders, or they were not listened to, or all of the above. Not a pretty sight.

Even now, with institutions starting to engage in self-analysis regarding the financial crisis, we are coming to appreciate the intense strains the mammoth financial services firms have been under. Overseeing multiline businesses over multiple geographies with hundreds of thousands of employees is a herculean task. In this regard, the commendable work certain large institutions have done in examining their own problems, including their inability to integrate risk measurements across the financial services platform, is most revealing.

Accounting systems. Whether or not new rules have produced a clearer picture of financial reality - a highly debatable point - they certainly have created counterproductive volatility. We have found our accounting and other regulations to be almost entirely pro-cyclical. They were instrumental in ensuring that the banking industry went into this crisis with loan-loss reserves that have proven inadequate.

Accounting rules have made acquisitions by strategic buyers more difficult. They have led to financial statements based in part on what the Street refers to as "mark to make believe."

Potential sources of assistance. …