Session 190 Systemic Risk Regulation Friday, October 22 11:30 - 1:00 pm FMA, New York

Managing systemic risk is viewed by many as the key to preventing future financial crisis, but what it is and how it is best dealt with is
not well understood. All the panelists have long and distinguished records on topics and policy issues concerning the macroeconomic
importance of large, systemically-important banking organizations. Panelists will advance their views on the definitions of systemic
risks, on how lessening such risks will lower the probability of a future crisis, and on the practical questions of what policies could be
implemented given the recently passed financial legislation.

Moderator: S Wayne Passmore, Deputy Associate Director, Federal Reserve Board

Panelists
Viral Acharya, Professor of Finance Research Associate in Corporate Finance, New York University
Diana Hancock, Deputy Associate Director, Federal Reserve Board
Richard Herring, Jacob Safra Professor of International Banking; Professor of Finance; Co-Director, Wharton Financial Institutions
Center, University of Pennsylvania
Peter Lupoff, founder, CEO and Portfolio Manager, Tiburon Capital Management LLC

A Practitioner’s Take
Peter M. Lupoff
Tiburon Capital Management
 I. What is Systemic Risk?

• Risk that impacts the entire financial sector and real economy through cascading,
contagion and chain-reaction effects.
– Central Bank contracts liquidity
– Large private firm fails
– Natural disaster
– Terrorist attack
• Risks that individual firms cannot necessarily protect themselves against.
• The financial crisis of September, 2008 featured many examples of systemic risk,
including bank runs and illiquidity of asset classes.

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 I. Causes of this Ongoing Financial Crisis – Two Views
• The Market Did It
– Crisis was due to forces emanating from the market economy which the government did not control,
either because it did not have the power to do so, or chose not to.
– The Systemic Risk was a market failure that can be dealt with via government actions.
– International market forces beyond governmental authority were at work.
• World savings abroad drove down interest rates, concurrently, mortgage rates.
– Failure of regulators to intervene in Lehman’s failure.
• The Government Did It
– Crisis was due to forces emanating from the government.
– Government actions caused, prolonged and worsened the crisis. Limiting governmental power is
essential to minimize Systemic Risk.
– Excessive monetary easing by the Fed.
• Low interest rates led to a housing boom.
• Fannie and Freddie exacerbated matters, supporting the mortgage backed market, purchasing more higher risk
mortgages.
– Regulatory misperception that the seize up in the money markets was liquidity related, rather than
counterparty related.

• Points succinctly made by Professor John Taylor of Stanford, Jekyll Island speech May 12,2009

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I. Causes – Real House Prices vs 10 Year Treasuries

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I. Causes - Fed Funds Rate Last US Recession to Present

Source: Bloomberg

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 I. Our Conclusions – What Low Interest Rates Wrought

Wall Street
Rating
Challenged
World Agencies Investors
to Create
Awash in Provide Buy with
Higher
Investment Ratings on Decreasing
Yielding
Capital Untested Scrutiny
Investment
Product
Grade Paper
•Low interests rates •Wall Street • History with auto- •Pervasive low
drive down yield on responds to backed paper. interest rates
IG paper. demand with over- • Deluge of new continues cycle.
•Enormous demand collateralized asset ratings requests •Less and less
for “high grade” backed securities. drives significant scrutiny by all
investment assets. •Single loan default new revenues for parties as demand
histories suggest ratings agencies. escalates,
adequate coverage. •Rating agency’s underlying asset
moral hazard. values increase.
•Incentives drive
each part of chain
to work as
aggressively as
possible to book
new business to
meet demand.
Why Was There No Attempt to Quell this Burgeoning Asset Bubble By Raising Rates?
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 I. Our Conclusions
• Market risks are not Systemic Risk.
• Mistakes in markets are made, corrections occur without systemic shock.
• Government actions, in part, converted market risks to systemic risk.
• Low interest rates forced global investors to reach for yield.
• The match that lit the fire.
• Wall Street innovation in asset-backed securities with implied “AAA” rating
met the need.
• Low interest rates led to low cost mortgages, driving up home prices.
• Low delinquency and foreclosure rates comforted rating agencies,
underwriters and investors.
• Demand for paper, low interest rates, skyrocketing home prices drove an
extraordinary vicious cycle leading to declining standards and documentation.

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 II. Systemic Risks Markets Worry About

• Deficits and Growing Debt of the Federal Government

– Large percentage of GDP that is federal debt – in excess of 40%?
• CBO projects debt will be 89% of GDP by 2019.
– No stimulus from this deficit.
– Is excessive tax or excessive inflation the solution?
– How can private enterprise compete for capital versus sovereigns – crowding out effect.
• Fed’s Balance Sheet
– Questionable whether additional asset purchases will forestall inflation.
• Fed Market Interventions
– Fed intervention into operations of private business firms.
• Is it proper purview to intrude on employee compensation matters, priority of debt holders in restructurings, etc?
– AIG – why bail out all creditors and allow equity to remain outstanding? Costs all borne by taxpayers.
– Bear Stearns, Fannie and Freddie - bondholders paid, GM , Lehman, Chrysler - bondholder impaired.
• Many actions reverse previous modus operandi and perhaps rule of law.

• Runs and Liquidity

– Runs can begin at troubled institutions but spread to healthy ones.
– Runs can be set off by otherwise healthy institution’s “counterparty” exposure to an unhealthy one.

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 II. Systemic Risks Markets Worry About
• To Big to Fail – Systematically Important Firms
– The knowledge or suspicion that a firm is too big to fail changes the behavior of a firm and its
creditors because of moral hazard.
– Incentive to take more risks in an attempt to increase potential profits, since there will be less
downside if those risks turn out badly.
• Leverage
– Cycle of leveraging up in good times and de-leveraging promptly, forcibly, in bad times, is exacerbates
systemic risk.
• Payment, Settlement and Clearing Systems
– Derivatives and other over-the-counter contracts not processed promptly, nor represented with
adequate paperwork support.
– Vulnerability to counter-party risk
– Limited transparency
• Asset Bubbles
– We’ argue low interest rates were the catalyst for the run up of assets post 2004. Policies that call
for lower interest rates can cause another asset bubble. This is within regulator’s control.
– Tampering with rates seems to ultimately magnify the asset boom/bust cycle rather than moderate
it.

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III. Lessening Systemic Risk to Lower Probability of a Future Crisis

• Stop the Projected Systemically Risky Budget Deficits.

– Exit from the extraordinary monetary policy actions, and end the bailout mentality that
is taking the federal government further and further into the operations of businesses
and threatens the rule of law.
• Government Should Establish Clear and Consistent Rules.
– Stop changing them during the game, and enforce them. The rules do not have to be
perfect, but the rule of law is essential.
• Cease the Bailout Mentality. It will be necessary to let some firms fail. One way to
wean the system from bailout presumptions would be for the government to try to
stop chain reactions by helping the innocent bystander rather by rescuing the one
who gambled and lost. This is a principle that was used to end the bailout mentality
of the IMF in 2003 and it helped stop the bout of emerging market crises that
began in the 1990s.
• Specific, Delineated Regulator Responsibilities. Rather than form any additional
regulatory bodies, insist that the current ones become articulate in financial
instruments, their use and their risks and share data with each other.

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 IV. What’s Wrong with Dodd-Frank Financial Legislation
• Overreaching . The bill adds regulations and rules about many activities that had little or
nothing to do with the crisis.
– Consumer Financial Protection bureau to be housed at the Fed that is supposed to
protect consumers from fraud and other abusive financial practices. Yet it is not
apparent that many consumers were victimized during the financial boom years.
– The bill gives the Fed authority to limit interchange or “swipe” fees that merchants pay
for each debit-card transaction – Why?
• Price controls are undesirable, and this is what the Fed should be attuned to?
– SEC authority to empower stockholders to run their own candidates for corporate
boards of directors improves corporate governance?

• Expanded Authority of Regulators that Didn’t Act Once Already.

– The Fed could have tightened the monetary base and interest rates as the crisis was
developing, but chose not to do so.
– The SEC and various Federal Reserve banks-especially the New York Fed- had the
authority to stop questionable lending practices and increase liquidity requirements.
– Additional governmental discretionary power over banks, without clear rules for banks.
• Financial Stability Oversight Council, a nine-member panel drawn from the Fed, SEC, and other
government agencies.

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 IV. What’s Wrong with Dodd-Frank Financial Legislation
• Banks Can Still Count Risky Assets as Capital. Insufficient capital relative to bank assets was
an important cause of the financial crisis.

• Silent on Freddie and Fannie.

– In 2008 they held over half of all mortgages, and almost all the subprime mortgages.
They have absorbed an even larger fraction of the relatively few mortgages written after
2008.

• Potential Unintended Consequences. Many proposals in the bill will have highly uncertain
impacts on the economy.

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