Industry Talk 2009

•  The coast was still not clear as on a macroeconomic basis, as there was still massive deleveraging in the financial industry. Banks had large unrecognized losses (loans, commercial, mortgage-backed securities). Furthermore, the US unemployment rate was still at a high of 10-13%;

•  In previous economic recoveries, US consumer spending was a key driver of economic growth. Going forward, Professor Hurley foresaw that the US economy will not be as consumer-driven as before, thus adversely affecting a potential growth engine.

Professor Hurley then outlined the main points of his presentation relating to:

•  Institutions

•  Reforms – What is the current reform agenda on the table;

•  People – People in financial institutions and how they failed.

Institutions

With regard to institutions, Professor Hurley listed the major institutions which had roles to play – Investment Banks (IBs), Commercial banks (CBs), Credit rating agencies, homeowners and regulators.

Investment Banks (IBs)

In the original model (pre-1999), Professor Hurley noted that IBs were benign partnerships that sold information and advised on acquisitions and mergers, etc. However, post-1999, there were several developments:

•  Major IBs corporatized and were allowed to issue shares; and

•  The Securities Exchange Commission allowed IBs to leverage themselves 40 to 1 (banks were usually leveraged at 10 to 1).

As a result, the whole IB model went out of kilter and IBs displayed off-balance sheet assets (like other banks) and special-purpose vehicles (SPVs) that defied measurement and discovery.

Credit rating agencies

Prof Hurley then highlighted that in US, the 3 major credit rating agencies derived credit and FICO scores from 2 nd hand credit reports, instead of conducting their own due diligence. Hence there was a double delegation of responsibility for proper due diligence. Moreover, the business model of credit ratings agencies is rife with conflicts of interest and other abuses.

Homeowners

Professor Hurley expressed doubts about the timing and essence of the Obama plan. He noted that instead of developing creative programmes for homeowners to rent and at least preserve their homes, the Obama administration was asking, “Who's suffering worst?” and spending a lot of time on modifications for homeowners facing foreclosures. The vast proportion of these modifications redefault and simply serve to drag out the inevitable decline in housing values thus postponing a robust recovery.

Regulators

Professor Hurley highlighted the extensive debate on the integrated approach versus the functional approach for regulators, however, he felt that the above debate diverted attention from the real issue - who were the people, and what were their motivations as regulators?

Reform Agenda

Professor Hurley proceeded to outline the main thrusts of the Obama Administration's detailed reform agenda proposals, which included the following:

•  Proposal for a new consumer financial protection agency in Washington , which will take over authority from the Federal Reserve in this area;

•  Provisions for systemic failure of the banking industry; and

•  Provisions to regulate OTC derivatives and the ‘shadow' banking system.

He felt that the Obama administration misdiagnosed the crisis as a regulatory problem. Rather, he opined, that the crisis had revealed a “number of rocks in the harbour”, i.e. unsustainable business practices.

Professor Hurley noted that the creation of a new consumer protection agency addressed “yesterday's problems”. He questioned the need for a new agency, when there were already so many regulatory agencies.

The Notion of “Too Big to Fail”

Professor Hurley next highlighted the on-going debate about the fact that certain organizations were seen as “too big to fail” and noted that other issues needed to be considered, such as were these organizations too interconnected, too leveraged and had too many counterparties? He felt that we had allowed the creation of institutions that were too big to regulate, too big to manage and hence posed risk to the financial system and questioned whether organizations that were deemed too large should be broken up.

Conclusion

Professor Hurley proposed two solutions:-

•  Return subsidies to taxpayers – Professor Hurley noted that “too big to fail” firms (e.g. Fannie Mae, Freddie Mac) had a quantifiable measureable advantage (e.g. lower cost of funds) over smaller firms and as this subsidy was purely attributable to taxpayers. He suggested that firms should be required to return the subsidy to the general treasury in the form of a premium, tax, or surcharge. This subsidy has been calculated to be approximately $34 billion annually, a large enough figure to cause TBTF firms to shrink or become less complex.

•  Fiduciary duty to taxpayers – Professor Hurley proposed that “too big to fail firms” should have a standard of “do no harm” to taxpayers. He noted that the duty of care that directors and officers owe to shareholders should be extended to taxpayers and suggested that the standard should be enforced by taxpayers themselves in the manner of derivative actions This approach would be a natural progression of the duty that officers and directors owe to creditors when their firms operate in what is known as the “zone of insolvency.”

Professor Hurley also commented on a range of issues including compensation, the independence of directors and the need for credit rating agencies to manage or eliminate their conflicts of interest.

Professor Hurley then made several predictions including the following:-

•  There will be a stalemate on the “too big to fail” issue;

•  The Federal Reserve will have weaker powers, partly due to past policies under Alan Greenspan, such as maintenance of low interest rates which contributed to the housing crisis, the anti-regulatory attitude and failure to pass consumer regulation;

•  The OTC Bill will be substantially strengthened to cover other areas of financial markets which need to be covered.

Professor Hurley's insightful presentation was then followed by a lively discussion and Q & A session (moderated by Ms Mimi Ho, Principal, Regulatory Professionals) with the attendees. Among the issues raised during this session were the critical issue of “too big to fail” and the phenomenon of the “irrational exuberance bubble”; getting the right people in the right place and future blind-spot such as asset bubbles in the housing market and certain commodities.