A report issued last week by financial industry leaders calling for greater private initiatives in containing systemic risk was greeted by some analysts as being a “no-brainer.” “Changing rules in assessing your counterparty risk seems to be a no-brainer in the context of what we’ve seen happen,” said Kurt Schacht, managing director of the CFA Institute Centre for Financial Market Integrity in New York. “Counterparty risk and how you analyze, consider and reflect that — both in your investment decisions and business decisions — is part and parcel of what you do,” he said.
The CFA Institute Centre is part of the CFA Institute in Charlottesville, Va., which certifies chartered financial analysts.
Last week, the Counterparty Risk Management Policy Group, composed of 16 officials from Wall Street’s major investment banks as well as other firms active in financial services, sent a 176-page report to Treasury Secretary Henry Paulson and Mario Draghi, governor of the Bank of Italy, proposing improved industry disclosures and oversight of risks in the wake of the past year’s credit market problems.
The report, “Containing Systemic Risk: The Road to Reform,” called for a significant shift of off-balance sheet status entities to on-balance sheet status, better disclosures and better sales and marketing practices for high-risk financial instruments.
It also called for strengthened issuer and loan diligence and sweeping measures to enhance credit-market monitoring, placing special emphasis on over-the-counter derivatives and credit default swaps.
Finally, it suggested creation of a new entity to clear credit default swaps, starting in the fourth quarter.
The report was issued at a press conference in New York last Wednesday, a day before the Securities and Exchange Commission and state regulators announced a settlement with Citigroup Inc. and Merrill Lynch & Co. Inc. both of New York for a voluntary buyback of troubled auction rate securities (see story on page 1).
The financial crisis is “the most severe we have experienced in the post-war period,” the Counterparty Risk Management Policy Group wrote in a letter to Mr. Paulson and Mr. Draghi. While the crisis has many causes, “the root cause of financial market excesses on both the upside and the downside of the cycle is collective human behavior — unbridled optimism on the upside and fear bordering on panic on the downside,” the letter said.
The recommendations made by the policy group would likely require market participants “to make costly investments in infrastructure,” as well as change business pro-cesses that in the past have generated “sizeable revenues but at the cost of weakening the underlying foundation of the markets,” said the letter. But, it added, those costs would be “miniscule” compared with write-downs of hundreds of billions of dollars undertaken by financial institutions in recent months.
“They are trying to clean up themselves, not letting regulators come in and impose new rules on them,” said Lance Pan, director of investment research at Capital Advisors Group Inc. in Newton, Mass., which manages $7 billion for institutional investors.
“They’re focusing on putting in more expensive systems,” he said.
“We already have more complex systems. The problem is not that the systems don’t work, but people don’t enforce them,” Mr. Pan said.
Simplification is needed right now, he said.
“The more bells and whistles in a machine, the more likely a machine will break down.” Mr. Pan said.
A key area that he thinks warrants more focus is the way financial companies reward their officials.
“During the boom years, a good risk manager is not properly rewarded,” Mr. Pan said.
On the other hand, “the financial reward from the excess risk that you take — it doesn’t get taken back when the market collapses,” he said.
E-mail Sara Hansard at email@example.com.
By Sara Hansard