The New York Times reported:
Obama to Propose Limits on Big Banks - NYTimes.com
IMO, this is a potentially important and welcome development for a number of reasons:
1. Human nature, being what it is, assures the temptation to pursue large risks will not dissipate.
Agreed
2. In spite of the financial crisis and deep recession that occurred from the collapse of the housing bubble, stunning little has changed in the financial sector. Failure to change includes:
Little sign of fundamental improvements to risk management. A lack of credit growth due to financial constraints and fear has provided the biggest check to risky practices, but once the fear dissipates the underlying risk management framework remains essentially the same
This is not correct. Leverage ratios at have come down at the major institutions. Credit standards have been tightened.
1. Little evidence that the financial sector is giving substantially greater consideration to history relative to modeling in its risk management practices, even as risk is largely a human nature/behavior + firm/industry structure & linkages problem
Do you have a basis for this comment? The CEOs of the companies at the FCIC meeting stated the opposite.
2. The failure to junk, dramatically revise, or narrow the focus of the use of models, including but not limited to VaR (value-at-risk), that performed poorly during the crisis and failed to flag important risks ahead of the financial crisis and, according to some noted economists e.g., Nobel Laureate Joseph Stiglitz, actually amplified risks. IMO, VaR can and should play a modest role in understanding risk, but it should not be the full or even largest answer to understanding risk. In effect, it could offer one set of scenarios, but other methods, including a rigorous and continuing assessment of history and structure, should be a regular part of any robust and dynamic risk management system that incorporates new lessons and evolves as industry and linkages evolve. Such an approach would require more human and financial capital, but the financial crisis is just the latest such event to demonstrate that risk management cannot be completely automated, models (simplifications themselves) cannot provide the whole answer to understanding risk, and models should guide but not replace human judgment when it comes to managing risk.
This statement is agreed by all I think. I have not heard any financial institution that said " the model " did it. Models played a role, faulty judgement played a role, lousy ratings from the rating agencies ( who Obama never mentions) were a big problem, Fannie and Freddie with fed guarentees of trillions in bad loans, mortgage origination was a huge problem. The list goes on.
Simple answers are fun, but hardly ever accurate.
3. Bonuses being awarded as a share of revenue
not profits in several financial sector firms, in effect rewarding top line growth even if bottom line growth is sacrificed or does not materialize during the compensation period. Down the road, such behavior would lead to a renewed acceleration of credit growth and decline in credit standards.
How do you think revenue is defined for a financial company like GS?
4. A Continuing mismatch between bank insurance premiums and the size/risk of such institutions. IMO, just as risk scales with firm size, insurance premiums should scale with size so as to provide a better match between future costs to the insurance fund and a firm's risk.
Just not accurate in my view. I do not understand the concept of a larger portfolio means higher risk. Did you mean higher leverage. Size is meaningless if the leverage ratios are in line.
5. Absence of accounting reform, to date, that would largely eliminate practices that keep risk off the financial statements, require the grossing of derivatives exposures on the balance sheet, and new financial sector presentation introduced by several accounting professors that would require differentiating between actual outcomes and forecasted outcomes (that's a technical detail that goes beyond the scope of this message, but suffice it to say valuations of certain items are really forecasts based on the assumption that the cash amounts will be realized as they are stated), etc.
Agreed. But this is not something that the financial institutions have control of. Speak to the AICPA. The SEC could ask for different type of reporting. So could the bank regulators.
All said, I believe the Volcker approach contributes toward a regulatory structure that would address the financial sector risk/risk management environment as it actually exists, not the idealized idea that predated the rise of the housing bubble prior to the financial crisis.