Magazine article Risk Management

Mending a BROKEN Banking System

Magazine article Risk Management

Mending a BROKEN Banking System

Article excerpt

In 1360, a Barcelona banker was executed on the steps of his failed bank. In 2008, when AlG, a company known for its big bonuses and risky investments within its financial products division, was on the verge of bankruptcy, it was not allowed to die. Instead, the Federal Reserve stepped in to save the insurance giant and sent AlG a check for $85 billion, a tab that ballooned to $ 1 70 billion within a few months.

It soon became apparent that AlG was far from the only financial firm in need of a life preserver to stay afloat, and Washington created the $700 billion Troubled Asset Relief Program to rescue the banks. Given the unprecedented sums of taxpayer money going to Wall Street, a public outcry for strict banking regulation immediately followed. This could never happen again.

But as Congress has focused more closely on the health care debate, financial reform has seemingly been pushed aside. And as the stock market has slowly risen (the S&P is up nearly 60% since its 13-year low on March 9, 2009), fears of another financial disaster have subsided. It looks as though the financial industry, glowing again with selfconfidence, may now have the clout to defeat reforms.

In January, President Obama vowed that he would put a stop to the excessive risk taking of large financial institutions, claiming that they nearly brought down the entire U.S. economy by taking "huge, reckless risks in pursuit of quick profits and massive bonuses." But so far, neither the administration nor Congress has done much to mend what many perceive as a broken system in need of an overhaul. They have, however, introduced some proposed regulations.

One possibility is the Volcker Rule, named after former Federal Reserve chairman and current chairman of Obama1 s Economic Recovery Advisory Board, Paul Volcker. The Volcker Rule aims to prohibit bank holding companies from owning, investing or sponsoring hedge fund or private equity funds and from engaging in proprietary trading (when firms trade from their own account for profit). Some feel the focus should not be on banning proprietary trading because, for most investment firms, trading their own account essentially makes up for only a few percentage points in terms of total revenue. Others feel proprietary trading is risky enough to bring down an entire bank - or economy for that matter - and should be prohibited.

The administration has also proposed a bank tax that targets institutions that rely on short-term borrowing. The plan, known as the Financial Crisis Responsibility Fee, would tax large banks based on their exposure to risk as a way to recover taxpayer losses from the 2008 bailout. The fee would fall most heavily on the nation's top banking institutions, such as Citigroup, JPMorgan Chase, Bank of America, Wells Fargo and Goldman Sachs. One Wall Street Journal estimate projects tliat such a tax would cut 5% of the banks' revenues mis year.

As expected, these proposed rules have attracted a lot of criticism aimed at the administration from both political conservatives and the banking industry. But Obama claims he is not backing down. "If these folks want a fight, it's a fight I'm ready to have," he said. Thus far, it seems the fight has yet to begin.

Betting on Basel

In the late 19th century, a typical British or American bank had a core capital equivalent to 1 5% to 25% of its total assets. Heading into the financial crisis of 2008, some U.S. banks' core capital was only 3% of their assets - or less - and less than one-tenth of those assets were liquid, or easily accessible. Overleveraged to such staggering degrees, few major institutions had reserves as a buffer to protect them from the ensuing financial disaster.

Blame was placed on quants who relied heavily on financial models such as value at risk (VaR) and the Gaussian copula function, a complex formula used throughout the financial industry that allowed large, complicated risks to be modeled with more ease and supposed accuracy than ever before. …

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