October 28, 2008Consistency, Transparency, and Thinking and Acting Globally Are Necessary as Washington Seeks to Restore Trust in U.S. Financial Markets
"Good morning, everyone - and for those of you visiting from out-of-town: Welcome to New York. As Mayor let me say: Please spend lots of money while you're here. We've got some gaps in the City budget that we'd be happy to have you help us close.
"Blythe and Tim have really lined up quite a day for you. For example: You're having Treasury Secretary Hank Paulson for lunch! You know, that's probably the way he felt during all those Congressional hearings last month, too. Nevertheless, I'm sure he sees this as a welcome chance to get out of the office and take a break from signing all those dollar bills. Then at dinner, you'll be hearing from former Treasury Secretary Larry Summers - who may be working on getting his signing hand limbered up again… just in case.
"That's because, with Election Day now just a week away, a new administration will soon be headed to Washington. As I've written in the current Newsweek, once in the White House either Senators McCain or Obama will have to confront any number of major long-range challenges: Rebuilding our infrastructure, re-directing our energy policy, working for immigration reform, and improving our nation's schools chief among them.
"Restoring long-term confidence in our capital markets also will clearly be a top priority. Over the past six weeks, Secretary Paulson and Federal Reserve President Bernanke have taken truly unprecedented steps to stabilize those markets. So have governments and central bankers around the world. Their efforts appear to have stopped the global economy from going over a precipice. But to paraphrase Winston Churchill's description of early Allied victories in World War II: This is not the end, or even the beginning of the end. It's really just the end of the beginning. Now the curtain is about to go up on Act Two.
"It will be all about reforming a regulatory structure that is a product - or perhaps one could call it a relic - of government's haphazard attempts to keep pace with innovations in the financial markets. We now can see that it is a painfully inadequate patchwork system, with some agencies that overlap unnecessarily, while at the same time major areas of the financial market are utterly overlooked. It's a regulatory regime that has not kept step with 21st century global finance.
"Many parts of it date from the era of the motorcycle sidecar and the snap-brim fedora - and their creakiness shows. But the fast pace of innovation in finance has made even agencies of more recent vintage badly out-of-date. For example, when the Commodity Futures Trading Commission was established in the mid-1970s, the products being traded were, by and large, agricultural futures.
"Today, however, financial futures - which actually more closely resemble financial securities - make up the bulk of such trading. Some financial products that are very similar to one another are overseen by separate and 'siloed' regulatory bodies. In other cases, products and financial institutions are regulated very lightly, or not at all - in large part because their true nature is understood very poorly. And we've all just had a very powerful object lesson in how hazardous that can be.
"As most of you know, I'm no stranger to Wall Street. I went straight from business school to a position with Salomon Brothers. For 15 years, I rose through the ranks there, working productively and happily right up to the day I was fired. That's a reminder to all of you that if job security is your top priority, you might want to consider another line of work.
"However, there was a happy ending. I landed on my feet and founded a successful financial information services firm. We named our first product the 'Market Master.' But that sounded like something that belonged in a kitchen instead of an office, and nobody called it that anyway. Our customers always referred to it as 'the Bloomberg,' so we started to do that, too. Our marketing tagline became: 'If you're not in front of a Bloomberg, you're behind.' And even though you're not at your desks today, you're still in front of a Bloomberg. I hope it's still a rewarding experience!
"The widespread use of Bloomberg terminals also says a lot about the culture and operation of today's financial markets. Because not only do those terminals provide loads of real-time information to the companies smart enough to lease them, other computers now decide when to buy or sell stocks and bonds.
"Automated trading was an inevitable development - and mostly, it's been a positive one. But it has added an extra, higher gear to the market's volatility. Because when the herd mentality gets automated, the stampede gets turbo-charged. And both the high-tech tools that traders use, and the highly complex products they sell, have, too often, out-stripped the sophistication of regulatory bodies, bond-rating agencies, investors and many financial executives, too.
"That discontinuity certainly accelerated the alarming free fall the financial markets experienced this fall. Why? Because what we all learned in our economics classes happens to remain true: Without clear and reliable information, markets can't work properly. Credit markets freeze up and capital markets collapse. That makes restoring trust in the operation of those markets critical.
"The question now is how to do that.
"There will be no end of answers from think tanks, current and former regulatory officials, financial columnists and journalists, as well as from people with long experience in both government and the private sector. In that last category, I certainly include Tim, who presented very thoughtful ideas in his testimony about regulatory reform on behalf of SIFMA to the House Committee on Financial Services last week. Ultimately, the devil, as always, will be in the details of any new regulatory regime - details that will be worked out by the next Administration and by Congress.
"For now, let me suggest that there are three over-arching principles that should guide them, and us, as this work goes forward. They are: consistency, transparency, and thinking and acting globally.
"First, we need greater consistency, because now financial institutions and products that are very similar to one another either aren't regulated in the same ways, or aren't regulated at all. Insurance companies, for example, are regulated almost entirely by the states - yet, as we saw with AIG, there isn't much difference anymore between an insurance company and an investment bank. There is even less difference between an investment bank and a hedge fund - yet hedge funds are almost completely unregulated. Like football receivers who excel in exploiting the seams in the opposition defense, finance capital thrives on finding the seams in the regulation of markets.
That produces new capital, which is good so long as financers bear in mind their principal function: Helping to put that capital to productive use. Things start to go wrong when the focus turns instead to creating increasingly opaque and esoteric financial instruments, and devising ways to elude their oversight. Take, for example, credit default swaps. In essence, they're a form of insurance designed to spread investment risks. But they aren't called insurance contracts. Why not? Because if they were, it would be an invitation to regulation. Unfortunately, such semantics have perhaps proved too clever by half.
"So as Tim testified last week, what we may now need is a 'market stability regulator' with access to information about financial institutions of all kinds, including banks, broker-dealers, insurance companies, hedge funds, and private equity funds. Similarly, Hank Paulson - and we are very lucky to have him as Treasury Secretary - has called for giving the Federal Reserve greater authority to access vital information on just such a wide range of financial institutions. And whatever stability regulator is created, it also may well be wise to grant it the authority to set consistent capital requirements for any public or private institution managing and investing large amounts of other people's money.
"Second, as to transparency. To work efficiently, markets need liquidity. And the great enemy of liquidity is uncertainty. When investors can't clearly see and assess the risks and rewards of financial instruments, they shun them. This fall, they've begun to describe accepting such instruments as being like 'catching a falling knife' - something any sensible person would avoid. Often these are custom-created securities that require enormous computer power to model, and that rest on impossible-to-value underlying assets.
"Further, it is probably true, as has been alleged frequently, that the managers of institutions holding these assets don't understand their risks, or their volatility. All this uncertainty puts downward pressure on their value, which hurts a firm's credit - which limits its ability to do business. That, in turn, puts further downward pressure on asset values, and the cycle continues - sometimes, as we've seen, spiraling all the way to the bottom.
"Sunlight remains the best disinfectant; greater transparency is the antidote to this uncertainty. It will help restore the confidence and trust needed to break the downward cycle I just described, and to keep it from recurring.
"I have, for example, always been a very big fan of tight requirements on disclosure of financial statements - which is why I've never thought that Sarbanes-Oxley was the worst thing that ever happened. Especially during tough times, I want to know that the financial statements of the companies I invest in are accurate and disclose the real situation. That's what Sarbanes-Oxley tries to do. Is it perfect legislation? No. We should make it simpler for companies, more efficient to file, and we should consider exempting foreign companies from certain of its requirements, which may mirror regulations they already comply with in their home nations. But in the end, the great, historic strength of American capital markets has always been confidence in what you read in financial statements. We must build on that strength going forward.
"Third and finally, there's the need to think and act globally. Today's regulations are written and enforced as though the financial world stops at our borders. But the panics that countries around the world have experienced, and the freezing up of global credit markets, tell a far different story. Capital now moves around the world at the speed of light. Companies are more mobile than ever. Countries are increasingly inter-dependent on each other for goods and services. And emerging economic powers, including China and India, have become - for the first time in history - major exporters of capital.
"All that means several things. It certainly means that any American retreat into protectionism would be a big wrong turn. We are inextricably a part of a global financial system in a global economy.
"It also means that we should expand the roster of nations with whom we work to solve global financial problems. I believe the U.S. has an obligation to lead the way in doing this. The international conference of 'G-20' nations that President Bush will host in Washington on November 15th is a good first step. And I'm confident that the next President, whoever he is, will continue on that path.
"We also need to start thinking about how to ensure that the accounting and financial regulatory standards in all these nations are consistent across borders and also that they are consistently enforced.
"Before closing, let me state a caveat and also cast a vote of confidence.
"The caveat is that financial regulation will ever be a delicate balancing act. Like Goldilocks, we need a bowl of porridge - or in this case a regulatory regime - that's not too cold, not too hot, but just right. We need consistency and transparency in the financial markets without creating regulation that's too burdensome or onerous. We need simpler regulatory structures able to work effectively and efficiently across a wide range of financial institutions, and able to anticipate and adapt to rapid changes in the markets.
My vote of confidence is: I believe completely that we can do it. And as the Mayor of the world's greatest financial center, I believe that New York and New Yorkers will play a leading role in doing that. The line-up of talent in our city's financial and regulatory institutions is truly extraordinary. The extraordinary efforts they've helped make in containing this fall's market upheavals I believe shows that we remain up to any challenge.
"And our message to the next President - and also to the members of SIFMA - is: We're ready to help. Just call.
"In the meantime, good luck to you all, and have a great conference."