Preventing the Next Crisis - Panel Recap

I would like to thank both Professor Slaughter and Mr. Flexner for a rousing and candid discussion on Preventing the Next Crisis.

The potential downside of the "Charlie Rose format" is that the audience may receive an overdose of one viewpoint. For this format to succeed, the questioner must be talented, dynamic, and willing to push the guest. Professor Slaughter was all of these things, presenting alternate viewpoints with his questions and continually pushing Mr. Flexner to support his assertions. The result was a substantive discussion as dense and insightful as one would expect from a Squam Laker and Citigroup's Global Head of Real Estate.

The themes for the first segment--how did we get here?--were conjuncture and interconnectivity. Conjuncture, as defined by Mr. Flexner, is the unexpected correlation of normally unrelated events or conditions. In the context of the financial crisis, the industry's reliance on value at risk (VAR) modeling produced a risk management regime that ignored low probability, high consequence risks. This statistical model had a blind spot: the conjuncture of falling housing prices, subprime mortgages, and the overnight downgrading of many AAA positions to CCC positions. In response to this conjuncture, firms began managing down their inventory exposure but it was all for naught thanks to the interconnectedness of (i) geographically diverse real estate markets by subprime mortgages, and (ii) the various investment houses. Ultimately, Mr. Flexner concluded that there were a number of elements that created the "perfect storm," but ultimately the root cause was an intellectual failure of economics. Mr. Flexner explained that markets cannot always internally correct, and that more than a light regulatory touch is needed but that the regulation must be sensible.

The themes of the second segment, addressing this question of sensible regulation, were that the Dodd-Frank Act is not the answer and that we must decrease interconnectivity between banks.

- The Dodd-Frank Act: Much like Mr. Pitt's keynote address, Mr. Flexner expressed concern that the law of unintended consequences will consume Dodd-Frank. Specifically, the line between proprietary trades and client services is sufficiently blurry that drafting effective regulations on the issue may be impossible. Even in discussing the Act's one admitted strength--derivatives regulation--the admission was prefaced by concerns about the second and third order consequences. Mr. Flexner's preferred alternative to Dodd-Frank is something akin to the Basel II & III agreements, which itself is a double-edged sword because (i) the implementation timeline is unacceptable for banks, which can't simply standby until 2017; and (ii) it heavily discriminates against all non-investment grade businesses. Notwithstanding its feasibility, Mr. Flexner's Basel advocacy is reminiscent of Mr. Pitt's sentiment that "American geocentrism is a disease," and that regulatory competition is necessary in the near future.

- Interconnectivity: Mr. Flexner stated that there is no such thing as too-big-to-fail but there is such a thing as too-interconnected-to-fail. Similarly, Professor Slaughter emphasized that we need to find a way "to allow bad firms to die without taking others with them." Both comments indicate that sensible regulation must focus on decreasing interconnectivity between banks. The two first-order suggestions for accomplishing this were capital requirements and liquidity requirements. Mr. Flexner insisted that not only do we need higher capital requirements for banks, but that the type of capital should be true common equity, not AAA rated mortgage-backed securities. On liquidity, Mr. Flexner suggested that we start using prospective stress tests to determine firm resilience, e.g. a 1-year net stable funding ratio.

- Mr. Flexner's third, more general, suggestion for sensible regulation is to plug the regulatory cracks so that Wall Street "cockroaches," as he jokingly referred to them, can't get through. When new regulation decreases returns, the natural human response is to take on more risk. Thus, if there are cracks in our regulatory response to this crisis, the "cockroaches" will have their day.

As in-depth as this panel discussion was, the topic is an exceedingly complex one and raised new questions for this listener:

- The panelists indicated that the VAR model's shortcoming means regulation is the safeguard against low probability catastrophes. However, one need look no further than the BP oil spill to see that government has difficulty with this. At the same time, complex statistical modeling is the financial sector's bread and butter. Thus, the issue of who should manage these conjuncture risks remains unsettled.

- We are still at the whims of obviously fallible bond rating houses. Do we need to rethink this reliance?

- To paraphrase Mr. Pitt: like it or not, Dodd-Frank is law and we have to learn to deal with it. Today's panel provided many suggestions for how to improve upon Dodd-Frank, but whether such reforms are possible is uncertain at best. Thus, as the new regulations are promulgated we will have to learn to manage our systemic risk within this framework. The obvious question, then, is: are there are ways to shape the forthcoming regulations to improve Dodd-Frank's risk management impact?

I would enjoy hearing others' thoughts on these questions and any others that the panel raised. Also, I welcome anyone to point out errors or omissions in my coverage of this very dense discussion.