Dollars and Jens
Wednesday, February 11, 2009
mark to market and financial regulation
Lloyd Blankfein in the FT:
Last, and perhaps most important, financial institutions did not account for asset values accurately enough. I have heard some argue that fair value accounting – which assigns current values to financial assets and liabilities – is one of the main factors exacerbating the credit crisis. I see it differently. If more institutions had properly valued their positions and commitments at the outset, they would have been in a much better position to reduce their exposures.I think a lot of banks are being squeezed by accounting regulations that require that they mark some things to market while they are forbidden to mark other things to market; if you make a loan and buy a CDS to protect the loan, you are better hedged from an economic standpoint, but not an accounting standpoint. The accounting standpoint becomes a little bit more real when you're subject to capital requirements, and that's another problem area here; some financial firms might well be able to recover given enough time, but the regulatory system — for some good reasons — won't give them that time if they acknowledge reality in their statements. Blankfein comes from a trading background, and he (like I) has a mark-to-market view. If everything is marked to market, I think that's a good idea, but some things are hard to mark to market, and doing so in a reasonable way requires discipline.
The percentage of the discretionary bonus awarded in equity should increase significantly as an employee’s total compensation increases. An individual’s performance should be evaluated over time so as to avoid excessive risk-taking. To ensure this, all equity awards need to be subject to future delivery and/or deferred exercise. Senior executive officers should be required to retain most of the equity they receive at least until they retire, while equity delivery schedules should continue to apply after the individual has left the firm.
...Capital, credit and underwriting standards should be subject to more “dynamic regulation”. Regulators should consider the regulatory inputs and outputs needed to ensure a regime that is nimble and strong enough to identify and appropriately constrain market excesses, particularly in a sustained period of economic growth. Just as the Federal Reserve adjusts interest rates up to curb economic frenzy, various benchmarks and ratios could be appropriately calibrated. To increase overall transparency and help ensure that book value really means book value, regulators should require that all assets across financial institutions be similarly valued. Fair value accounting gives investors more clarity with respect to balance sheet risk.
...After the shocks of recent months and the associated economic pain, there is a natural and appropriate desire for wholesale reform of our regulatory regime. We should resist a response, however, that is solely designed around protecting us from the 100-year storm. Taking risk completely out of the system will be at the cost of economic growth. Similarly, if we abandon, as opposed to regulate, market mechanisms created decades ago, such as securitisation and derivatives, we may end up constraining access to capital and the efficient hedging and distribution of risk, when we ultimately do come through this crisis.