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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.
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
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
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.
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.
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.
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.
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.
The president, for the first time, will throw his weight behind an approach long championed by Paul A. Volcker, former chairman of the Federal Reserve and an adviser to the Obama administration. The proposal will put limits on bank size and prohibit commercial banks from trading for their own accounts — known as proprietary trading...
Mr. Volcker flew to Washington for the announcement on Thursday. His chief goal has been to prohibit proprietary trading of financial securities, including mortgage-backed securities, by commercial banks using deposits in their commercial banking sectors. Big losses in the trading of those securities precipitated the credit crisis in 2008 and the federal bailout.
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.
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
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
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.
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.
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.
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.
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.
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