many of those companies owned federally insured depository institutions or had other access to explicit or implicit forms of support from the governme

TO BE NOTED: From the Treasury Department:

"March 26, 2009

tg-71

Treasury Secretary Tim Geithner Written Testimony House Financial Services Committee Hearing

Introduction

Thank you Chairman Frank, Ranking Member Bachus, and other members of the Committee. I appreciate the opportunity to testify about the critical topic of financial regulatory reform.

Over the past 18 months, we have faced the most severe global financial crisis in generations. Some of the world's largest financial institutions have failed. Equity and real estate prices have fallen sharply, eroding the value of our savings. The supply of credit has tightened dramatically. Confidence in the overall financial system, in the protections it is supposed to afford for investors and consumers, has eroded. These financial pressures have intensified the recession now underway around the world.

And as in any financial crisis, the damage falls on Main Street. It affects the vulnerable. It affects those who were conservative and responsible, not just those who took too much risk.

Our system is wrapped today in extraordinary complexity, but beneath all that, financial systems serve an essential and basic function. Financial institutions and markets transform the earnings and savings of American workers into the loans that finance a home, a new car or a college education. They exist to allocate savings and investment to their most productive uses.

Our financial system does this better than any other financial system in the world, but our system failed in basic fundamental ways. The system proved too unstable and fragile, subject to significant crises every few years, periodic booms in real estate markets and in credit, followed by busts and contraction. Innovation and complexity overwhelmed the checks and balances in the system. Compensation practices rewarded short-term profits over long-term return. We saw huge gains in increased access to credit for large parts of the American economy, but those gains were overshadowed by pervasive failures in consumer protection, leaving many Americans with obligations they did not understand and could not sustain. The huge apparent returns to financial activity attracted fraud on a dramatic scale. Large amounts of leverage and risk were created both within and outside the regulated part of the financial system.

These failures have caused a great loss of confidence in the basic fabric of our financial system, a system that over time has been a tremendous asset for the American economy.

To address this will require comprehensive reform. Not modest repairs at the margin, but new rules of the game. The new rules must be simpler and more effectively enforced and produce a more stable system, that protects consumers and investors, that rewards innovation and that is able to adapt and evolve with changes in the financial market. ( NB DON )

On February 25, after meeting with the banking and financial services leadership from Congress, President Obama directed his economic team to develop recommendations for financial regulatory reform and to begin the process of working with the Congress on new legislation. The Treasury Department has been working with the President's Working Group on Financial Markets (PWG) to develop a comprehensive plan of reform. This effort has been and will be guided by principles the President set forth earlier this year and in his speech as a candidate at Cooper Union in March 2008.

Financial institutions and markets that are critical to the functioning of the financial system and that could pose serious risks to the stability of the financial system need to be subject to strong oversight by the government. Our financial system and the major centralized markets must be strong and resilient enough to withstand very severe shocks and the failure of one or more large institutions. We need much stronger standards for openness, transparency, and plain, common sense language throughout the financial system. And we need strong and uniform supervision for all financial products marketed to consumers and investors, and tough enforcement of the rules to ensure full accountability for those who violate the public trust.

Financial products and institutions should be regulated for the economic function they provide and the risks they present, not the legal form they take. We can't allow institutions to cherry pick among competing regulators, and shift risk to where it faces the lowest standards and constraints.

And we need to recognize that risk does not respect national borders. We need to prevent national competition to reduce standards and encourage a race to higher standards. Markets are global and high standards at home need to be complemented by strong international standards enforced more evenly and fairly. These are global markets and challenges. Building on these principles, we want to work with Congress to put in place fundamental reforms that create a stronger, more stable system, with much stronger protections for consumers and investors, and a more streamlined, consolidated, and simple oversight framework.

I want to begin that process today by focusing on proposals that are essential to creating a more stable system, with stronger tools to prevent and manage future crises. In this context, my objective is to concentrate on the substance of the reform agenda, rather than the complex and sensitive questions of who should be responsible for what.

Over the next few weeks we will outline proposals in the areas of consumer and investor protection and for reform of regulatory oversight arrangements.

We start with systemic risk, not just because of its obvious importance to our future economic performance, but also because these issues require more cooperation globally, and they will be at the center of the agenda at the upcoming Leaders' Summit of the G-20 in London on April 2.

These proposals reflect a range of complex and consequential policy choices. They will require careful work and drafting. It is important that we get this right. We recognize there will be many alternative models put forth to achieve the objective we all share of creating a more stable system. And we look forward to working with the Federal Reserve, with the agencies that make up the President's Working Group on Financial Markets, and with the Congress on a package of reforms that we can all support.

The Crisis and Its Fundamental Causes

The current crisis had many causes.

Two decades of sustained economic growth bred widespread complacency among financial intermediaries and investors, lowering borrowing costs and weakening lending standards.

A global boom in savings resulted in large flows of capital into the United States and other markets, pushing down long-term interest rates and pushing up asset prices. The rising market hid Ponzi schemes and other flagrant abuses that should have been detected and eliminated.

In that environment, institutions and investors looked for higher returns by taking on greater exposure to the risk of infrequent but severe losses.

A long period of home price appreciation encouraged borrowers, lenders, and investors to make choices that could only succeed if home prices continued to appreciate. We had a system under which firms encouraged people to take unwise risks on complicated products, with ruinous results for them and for our financial system.

Market discipline failed to constrain dangerous levels of risk-taking throughout the financial system. New financial products were created to meet demand from investors, and the complexity outmatched the risk-management capabilities of even the most sophisticated financial institutions. Financial activity migrated outside the banking system, relying on the assumption that liquidity would always be available.

Regulated institutions held too little capital relative to the risks to which they were exposed. And the combined effects of the requirements for capital, reserves and liquidity amplified rather than dampened financial cycles. This worked to intensify the boom and magnify the bust.

Supervision and regulation failed to prevent these problems. There were failures where regulation was extensive and failures where it was absent.

Regulators were aware that a large share of loans made by banks and other lenders were being originated for distribution to investors through securitizations, but they did not identify the risks caused by explosive growth in complex products based on these products.

Investment banks, large insurance companies, finance companies, and the GSEs were subject to only limited oversight on a consolidated basis, despite the fact that many of those companies owned federally insured depository institutions or had other access to explicit or implicit forms of support from the government( NB DON ). Federal law allowed many institutions to choose among regulatory regimes for consolidated supervision and, not surprisingly, they avoided the stronger regulatory authority applicable to bank holding companies. Those companies and others were highly leveraged or used short-term borrowing to buy long-term assets, yet lacked strong federal prudential regulation and routine access to central bank liquidity.

And while supervision and regulation failed to constrain the build up of leverage and risk, the United States came into this crisis without adequate tools to manage it effectively. Until the Housing and Economic Recovery Act and the Emergency Economic Stabilization Act were passed in the summer and fall of 2008, the executive branch had effectively no ability to provide the capital or guarantees necessary to contain the damage caused by the crisis.

And as I discussed before this committee on Tuesday, U.S. law left regulators without good options for managing failures of systemically important non-bank financial institutions.

Regulation of a financial system as complex and dynamic as our system is inherently difficult and challenging. But that difficulty has been compounded by a U.S. regulatory structure that is unnecessarily complex and fragmented. The complexity has sometimes resulted in a failure to assign clear responsibility for achievement of some public policy objectives, notably for financial stability.

Toward a More Stable and Resilient Financial System

Our comprehensive framework for regulatory reform will cover four broad areas: systemic risk, consumer and investor protection, eliminating gaps in our regulatory structure; and international coordination.

In the coming weeks, I will present detailed frameworks for each of these areas. Today, I will discuss in greater detail the need to create tools to identify and mitigate systemic risk, including tools to protect the financial system from the failure of systemically important financial institutions.

Second, weaknesses in our consumer and investor protections harm individuals, undermine trust in our financial system, and can contribute to systemic crises that shake the very foundations of our financial system. The choice of what home mortgage to get or how to save for retirement are some of the most important financial decisions that households make. It is crucial that when households make choices we have clear rules of the road that prevent manipulation and abuse. We must restore integrity to our financial system and strengthen these protections. Consumer and investor protection is a critical component of the President's regulatory reform plan. We are developing a strong, comprehensive plan for consumer and investor regulation to simplify financial decisions for households and to protect people from unfair and deceptive practices.

We must end the practice of allowing banks and other financial companies to choose their regulator simply by changing their charters; regulators must choose who to regulate. Moreover, our regulatory system must be comprehensive and eliminate gaps in coverage. Our regulatory structure must assign clear regulatory authority, resources, and accountability for each of the key regulatory functions. We must not let turf wars or concerns about the shape of organizational charts prevent us from establishing a substantive system of regulation that meets the needs of the American people.

To match the increasing global markets, we must ensure that global standards for financial regulation are consistent with the high standards we will be implementing in the United States.

The Financial Stability Forum (FSF) has played an essential role in the effort, working with the world's standard - setting bodies to study the underlying causes of the crises and address these weaknesses. Much progress is being made to enhance sound regulation, strengthen transparency, and reinforce international collaboration.

We have begun to work with international colleagues to reform and strengthen the FSF so that it can play a more effective role alongside the original Bretton Woods institutions in strengthening the financial system. We have already gotten agreement to expand the membership to include all G-20 countries, giving it a stronger mandate for promoting more robust standards consistent with the principles above, and working with the IMF and the World Bank to monitor the implementation of those standards.

In addition, we will launch a new, initiative to address prudential supervision, tax havens, and money laundering issues in weakly regulated jurisdictions. President Obama will underscore in London on April 2 at the Leaders' Summit the imperative of raising standards across the globe and encouraging a race to the top rather than a race to the bottom.

Reducing Systemic Risk

The crisis of the past 18 months has exposed critical gaps and weaknesses in our regulatory system. As risks built up, internal risk management systems, rating agencies and regulators simply did not understand or address critical behaviors until they had already resulted in catastrophic losses.

This crisis has made clear that certain large, interconnected firms and markets need to be under a more consistent, and more conservative regulatory regime. These standards cannot simply address the soundness of individual institutions, but must also ensure the stability of the system itself. We need to strengthen our system of prudential supervision across the financial sector. We must require that firms build up capital during good economic times so that they have a more robust protection against losses in down times( NB DON ) – and can continue to lend to America's households and businesses big and small. We need to examine our accounting rules to see whether, consistent with investor protection, we can require firms to build up loan loss reserves that look forward and account for losses in downturns.

In addition, regulators must issue standards for executive compensation practices across all financial firms. These guidelines should encourage prudent risk-taking, incent a focus on long-term performance of the firm rather than short-term profits, and should not otherwise create incentives that overwhelm risk management frameworks.

The key elements of our plan to address systemic risk are:

First, we need to establish a single entity with responsibility for systemic stability over the major institutions and critical payment and settlement systems and activities.

Second, we need to establish and enforce substantially more conservative capital requirements for institutions that pose potential risk to the stability of the financial system, that are designed to dampen rather than amplify financial cycles.

Third, we should require that leveraged private investment funds with assets under management over a certain threshold register with the SEC to provide greater capacity for protecting investors and market integrity.

Fourth, we should establish a comprehensive framework of oversight, protections and disclosure for the OTC derivatives market, moving the standardized parts of those markets to central clearinghouse, and encouraging further use of exchange-traded instruments.

Fifth, the SEC should develop strong requirements for money market funds to reduce the risk of rapid withdrawals of funds that could pose greater risks to market functioning.

And sixth, we need to establish a stronger resolution mechanism that gives the government tools to protect the financial system and the broader economy from the potential failure of large complex financial institutions.

Systemically Important Financial Firms and Markets

To ensure appropriate focus and accountability for financial stability we need to establish a single entity with responsibility for consolidated supervision of systemically important firms and for systemically important payment and settlement systems and activities.

We can no longer allow major financial institutions to choose among consolidated supervision regimes and regulators or to avoid consolidated supervision entirely. That means we must create higher standards for all systemically important financial firms regardless of whether they own a depository institution, to account for the risk that the distress or failure of such a firm could impose on the financial system and the economy. We will work with Congress to enact legislation that defines the characteristics of covered firms, sets objectives and principles for their oversight, and assigns responsibility for regulating these firms.

In identifying systemically important firms, we believe that the characteristics to be considered should include: the financial system's interdependence with the firm, the firm's size, leverage (including off-balance sheet exposures), and degree of reliance on short-term funding, and the firm's the importance of the firm as a source of credit for households, businesses, and governments and as a source of liquidity for the financial system.

In general, the design and degree of conservatism of the prudential requirements applicable to such firms should take into account the inherent inability of regulators to predict future outcomes.

Capital requirements for these firms must be sufficiently robust to be effective farther into the tails of potential outcomes than capital requirements for other financial firms. And they must be less pro-cyclical, requiring firms to build up substantial capital buffers in good economic times so that they can avoid deleveraging in cyclical downturns.

The single systemic regulator will also need to impose liquidity, counterparty, and credit risk management requirements that are more stringent than for other financial firms. For instance, supervisors should apply more demanding liquidity constraints; and require that these firms are able to aggregate counterparty risk exposures on an enterprise basis within a matter of hours.

The regulator of these entities will also need a prompt, corrective action regime that would allow the regulator to force protective actions as regulatory capital levels decline, similar to that of the FDIC with respect to its covered agencies.( NB DON )

Payment and Settlement Activities

Weaknesses in the settlement systems for key funding and risk transfer markets, notably overnight and short-term lending markets (such as those for tri-party repurchase agreements) and OTC derivatives, have been highlighted as a key mechanism that could spread financial distress between institutions and across borders. While some progress was made in the markets for CDS and other OTC derivatives while I was at the New York Fed, federal authority over such arrangements is incomplete and fragmented, and we have been forced to rely heavily on moral suasion to encourage market participants to strengthen these markets.

We need to give a single entity broad and clear authority over systemically important payment and settlement systems and activities. Where such systems or their participants are already federally regulated, the authority of those federal regulators should be preserved and the single entity should consult and coordinate with those regulators.

Hedge Funds and Other Private Pools of Capital

U. S. law generally does not require hedge funds or other private pools of capital to register with a federal financial regulator, although some funds that trade commodity derivatives must register with the CFTC and many funds register voluntarily with the SEC. As a result, there are no reliable, comprehensive data available to assess whether such funds individually or collectively pose a threat to financial stability. However, in the wake of the Madoff episode it is clear that, in order to protect investors, we must close gaps and weaknesses in regulation of investment advisors and the funds they manage.

Accordingly, we recommend that all advisers to hedge funds (and other private pools of capital, including private equity funds and venture capital funds) with assets under management over a certain threshold be required to register with the SEC. All such funds advised by an SEC-registered investment adviser should be subject to investor and counterparty disclosure requirements and regulatory reporting requirements. The regulatory reporting requirements for such funds should require reporting, on a confidential basis, information necessary to assess whether the fund or fund family is so large or highly leveraged that it poses a threat to financial stability. The SEC should share the reports that it receives from the funds with the entity responsible for oversight of systemically important firms, which would then determine whether any hedge funds could pose a systemic threat and should be subjected to the prudential standards outlined above.

Credit Default Swaps and Other OTC Derivatives

The current financial crisis has been amplified by excessive risk-taking by certain insurance companies and poor counterparty credit risk management by many banks trading Credit Default Swaps (CDS) on asset-backed securities. These complex instruments were poorly understood by counterparties, and the implication that they could threaten the entire financial system or bring down a company of the size and scope of AIG was not identified by regulators, in part because the CDS markets lacked transparency.

Let me be clear: the days when a major insurance company could bet the house on credit default swaps with no one watching and no credible backing to protect the company or taxpayers from losses must end.

In our proposed regulatory system, the government will regulate the markets for credit default swaps and over-the-counter derivatives for the first time.

We will subject all dealers in OTC derivative markets and any other firms whose activities in those markets pose a systemic threat to a strong regulatory and supervisory regime as systemically important firms.

We will force all standardized OTC derivative contracts to be cleared through appropriately designed central counterparties (CCPs). We will also encourage greater use of exchange-traded instruments.

The CCPs will be subject to comprehensive settlement systems supervision and oversight, consistent with the authority outlined above.

We will require that all non-standardized derivatives contracts be reported to trade repositories and be subject to robust standards for documentation and confirmation of trades, netting, collateral and margin practices, and close-out practices.

We will bring unparalleled transparency to the OTC derivatives markets by requiring CCPs and trade repositories to make aggregate data on trading volumes and positions available to the public and make individual counterparty trade and position data available on a confidential basis to federal regulators, including those with responsibilities for market integrity.

Finally, we will strengthen participant eligibility requirements and, where appropriate, introduce disclosure or suitability requirements, and we will require all market participants to meet recordkeeping and reporting requirements.

Money Market Mutual Funds (MMFs)

In the wake of Lehman Brothers' bankruptcy, we learned that even one of the most stable and least risky investment vehicles - money market mutual funds - was not safe from the failure of a systemically important institution. These funds are subject to strict regulation by the SEC and are billed as having a stable asset value - a dollar invested will always return the same amount. But when a major prime MMF "broke the buck" - lost money - the event sparked sharp withdrawals across the entire prime MMF industry. Those withdrawals resulted in severe liquidity pressures, not only on prime MMFs but also on financial and non-financial companies that relied significantly on MMFs for funding. The vulnerability of MMFs to breaking the buck and the susceptibility of the entire prime MMF industry to sharp withdrawals in such circumstances remains a significant source of systemic risk.

We believe that the SEC should strengthen the regulatory framework around MMFs in order to reduce the credit and liquidity risk profile of individual MMFs and to make the MMF industry as a whole is less susceptible to runs.

Resolution Authority

As I discussed on Tuesday, we must create a resolution regime that provides authority to avoid the disorderly liquidation of any nonbank financial firm whose disorderly liquidation( NB DON ) would have serious adverse effects on the financial system or the U.S. economy.

Please note that the draft resolution legislation we have submitted is a first step intended to address a significant void in today's regulatory structure. This mechanism is intended to be a permanent authority and therefore, will also be a critical element of Treasury's broader regulatory reform proposals. As we move forward on those proposals, we will need to align the draft legislation with the broader regulatory reform effort as it develops. At this point, however, I will focus on how the authority and mechanism would work within our current regulatory framework.

We must cover financial institutions that have the potential to pose systemic risks to our economy but that are not currently subject to the resolution authority of the FDIC. This would include bank and thrift holding companies and holding companies that control broker-dealers, insurance companies, and futures commission merchants, or any other financial firm posing substantial risk to our economy.

Before any of the emergency measures specified could be taken, the Secretary of the Treasury, upon the positive recommendations of both the Federal Reserve Board and the FDIC and in consultation with the President, would have to make a triggering determination that (1) the financial institution in question is in danger of becoming insolvent; (2) its insolvency would have serious adverse effects on economic conditions or financial stability in the United States; and (3) taking emergency action as provided for in the law would avoid or mitigate those adverse effects.

The Treasury and the FDIC would decide whether to provide financial assistance to the institution or to put it into conservatorship/receivership. This decision will be informed by the recommendations of the Federal Reserve Board and the appropriate federal regulatory agency (if different from the FDIC). The U.S. government would be permitted to utilize a number of different forms of financial assistance in order to stabilize the institution in question. These include making loans to the financial institution in question, purchasing its obligations or assets, assuming or guaranteeing its liabilities, and purchasing an equity interest in the institution.

This authority is modeled on the resolution authority that the FDIC has under current law with respect to banks and that the Federal Housing Finance Agency has with regard to the GSEs. Here, conservatorships or receiverships aim to minimize the impact of the potential failure of the financial institution on the financial system and consumers as a whole, rather than simply addressing the rights of the institution's creditors as in bankruptcy.

Depending on the circumstances, the FDIC and the Treasury would place the firm into conservatorship with the aim of returning it to private hands or a receivership that would manage the process of winding down the firm. The trustee of the conservatorship or receivership would have broad powers, including to sell or transfer the assets or liabilities of the institution in question, to renegotiate or repudiate the institution's contracts (including with its employees), and to deal with a derivatives book. A conservator would also have the power to fundamentally restructure the institution by, for example, replacing its board of directors and its senior officers. None of these actions would be subject to the approval of the institution's creditors or other stakeholders.

The proposed legislation would create an appropriate mechanism to fund the appropriately limited exercise of the resolution authorities it confers. This could take the form of a mandatory appropriation to the FDIC out of the general fund of the Treasury (subject to all the restrictions on the use of appropriated funds, including apportionments under the Anti-Deficiency Act), and/or through a scheme of assessments, ex ante or ex post, on the financial institutions covered by the legislation. The government would also receive repayment from the redemption of any loans made to the financial institution in question, and from the ultimate sale of any equity interest taken by the government in the institution. The Deposit Insurance Fund will not be used to fund such assistance.

Conclusion

The President has made clear that we will do what is necessary to stabilize the financial system and restore the conditions for economic growth. Working closely with the Congress, we have moved quickly and with forceful action to help get people back to work and the economy growing again. With your help we are also moving to repair the financial system so that it works for, rather than against, recovery.

Comprehensive regulatory reform is critical to these efforts. In the coming days and weeks, we will continue to lay out the steps we must take to protect against systemic risk. We will also lay out a detailed framework for stronger rules to protect consumers and investors against fraud and abuse.

Next week I will join President Obama in London for the G-20 leaders meeting to build support - with the help of other interested nations and strengthened international bodies -for higher global standards for financial regulation.

We are a strong and resilient country. We came into the current crisis without the authority and tools we needed to contain the damage to the economy from the financial crisis. We are moving to ensure that we are equipped with both in the future, and in the process, that we modernize our 20th century regulatory system meet 21st century financial challenges."

"that still leaves open the question of how the system should be managed."

An interesting post on The Baseline Scenario by James Kwak:

"Financial innovation tends to be a bit of a bad word these days. But while I and many other people are in favor of an overhaul of our regulatory system, that still leaves open the question of how the system should be managed.

A reader pointed me to a 2005 paper by Zvi Bodie and Robert Merton on the “Design of Financial Systems.” They argue that neoclassical finance theory ( KANTIAN ) - frictionless markets, rational agents, efficient outcomes - needs to be combined with two additional perspectives:( 1 ) an institutional approach ( KANTIAN ) that focus on the structural aspects of the financial system that introduce friction and may lead to non-efficient outcomes; and ( 2 ) a behavioral approach ( EXISTENTIAL ) that focuses on the ways in which and the conditions under which economic actors are not rational (see my post on bubbles, for example). The paper walks through examples of how to think about some real problems we face, such as the fact that households are increasingly being forced to make important decisions about retirement savings, but generally lack the knowledge and skills to make those decisions. One of their arguments is that while institutional design may not matter in a pure neoclassical world, it does matter in the world of irrational actors( HUMAN AGENCY EXPLANATIONS ): deposit insurance to stop bank runs is an obvious example.

Some of the content may be tough going, but in general the paper offers one perspective on how to think about the relationships between markets, institutions, and individual behavior that make up our financial system."

It's an interesting paper, which, as far as I can tell, says that Financial Innovation is tied to the idea of giving investors more specific products that they can use to individualize and target their investments.

Here are some interesting quotes:

"Instead of examining each as competing alternatives, our central methodological thesis for implementing a functional theory of financial institutions is a synthesis of the neoclassical, the new institutional, and the behavioral perspectives on finance. We call this attempt to synthesize these three perspectives, Functional and Structural Finance (FSF).( IT'S A REASONABLE APPROACH, INTEGRATING KANTIAN AND EXISTENTIAL EXPLANATIONS )

"Derivative securities designed to function as adapters among otherwise incompatible domestic
systems were important contributors to effective integration. In general, the flexibility created by the widespread use of derivatives as well as specialized institutional designs provided an effective offset to dysfunctional country-specific institutional rigidities. Furthermore, derivative-security technologies provide efficient means for creating cross-border interfaces without imposing invasive, widespread changes within each system."( THIS IS A MAIN USE OF DERIVATIVES )

"This pipeline analogy captures much of what has been happening during the past twenty years in the international financial system. Financial engineers have been designing and implementing derivative contracts to function as efficient adapters that allow
the flow of funds and the sharing of risks among diverse national systems with different institutional shapes and sizes. More generally, financial innovation has been a central
force driving the financial system toward greater economic efficiency. Both scholarly research and practitioner experience over that period have led to vast improvements in our understanding of how to use the new financial technologies to manage risk.
As we all know, there have been financial “incidents,” and even crises, that cause some to raise
questions about innovations and the scientific soundness of the financial theories used to engineer them. There have surely been individual cases of faulty engineering designs and faulty implementations of those designs in finance just as there have
been in building bridges, airplanes, and silicon chips. Indeed, learning from (sometimes even
tragic) mistakes is an integral part of the process of technical progress.3
However, on addressing the overall soundness of applying the tools of financial engineering, it is
enough to note here the judgment of financial institutions around the world as measured by their
practice.Today no major financial institution in the world, including central banks, can function without the computer-based mathematical models of modern financial science. Furthermore, the specific models that these institutions depend on to conduct their global derivative pricing and risk-management activities are based typically on the Black–Scholes option pricing methodology."

Okay, this section doesn't exactly ring true anymore. However, the tools can still be effectively used, only with much more caution and a more realistic approach to the world. One can argue that is what they're doing in this paper, but their triumphalism does sound discordant today, at the very least.

With its foundation based on frictionless and efficient markets populated with atomistic and rational agents, the practical applicability of the neoclassical modeling approach is now challenged by at least two alternative theoretical paradigms. One, New Institutional Economics, focuses explicitly on transaction costs, taxes, computational limitations, and other frictions.5 The other, Behavioral Economics, introduces non-rational and systematically uninformed
behavior by agents.6 In contrast to the robustness of the neoclassical model, the prescriptions and predictions of these alternatives are manifestly sensitive to the specific market frictions and posited behavioral deviations of agents.7 Perhaps more latent is the strong sensitivity of these predictions to the institutional structure in which they are embedded. There is a considerable ongoing debate, sometimes expressed in polar form, between the proponents
of these competing paradigms. Those who attack the traditional neoclassical approach assert that the overwhelming accumulation of evidence of anomalies
flatly rejects it.8 They see a major paradigm shift to one of the new alternatives as essential for
progress. Defenders of the neoclassical paradigm respond that the alleged empirical anomalies are either not there, or that they can be explained within the neoclassical framework, and that in either case, the proposed alternatives do not offer a better resolution.9 That debate so framed is best left to proceed anomaly by anomaly and we say no more about it here.
Instead, we take a different approach. Rather than choose among the three competing theoretical perspectives, we believe that each, although not yet of the same historical significance, can make distinctive contributions to our understanding and each has its distinctive limitations." ( I WOULD AGREE WITH THIS )

Households today are called upon to make a wide range of important and detailed financial decisions that they did not have to in the past. For example, in the United States, there is a strong trend away from defined-benefit corporate pension plans that require no management decisions by the employee toward defined-contribution plans that do. There are more than 9000 mutual funds and a vast array of other investment products. Along with insurance products and liquidity assets, the household faces a daunting task to assemble these various components into a coherent effective lifetime financial plan. Some see this trend continuing with existing products
such as mutual funds being transported into technologically less-developed financial systems.
Perhaps this is so, especially in the more immediate future, with the widespread growth of relatively inexpensive Internet access to financial “advice engines.” However, the creation of all these alternatives combined with the deregulation that made them possible has consequences: deep and wideranging disaggregation has left households with the responsibility for making important and technically complex micro-financial decisions involving risk—such as detailed asset allocation and estimates of the optimal level of life-cycle saving for retirement—decisions that they had not had to make in the past, are not trained to make in the present, and are unlikely to execute efficiently in the future, even with attempts at education. The availability of financial advice over the Internet at low cost may help to address some of the information-asymmetry problems for households with respect to commodity-like products for which
the quality of performance promised is easily verified. However, the Internet does not solve the
“principal–agent” problem with respect to more fundamental financial advice dispensed by an agent.That is why we believe that the future trend will shift toward more integrated financial products and services, which are easier to understand ( NECESSARY ), more tailored
toward individual profiles ( GOOD ), and permit much more effective risk selection and control. ( NECESSARY )

Of course, this is the rational for financial innovation, but it must meet the required standards to be useful. So far, this seems doubtful, although, again, I don't blame the investments.

The preceding examples of behavioral distortions of efficient risk allocation and asset pricing all involve cognitive dissonance of individual agents.However, there is another dimension of potential behavioral effects that is sociological in nature in that it derives from the social structure of the financial system. Sociological behavior is neither under the control
of individuals within that social structure nor a direct consequence of simple aggregation of individual cognitive dysfunctions. A classic instance within finance is the Self-Fulfilling Prophecy (SFP),41 applied for instance to bank runs: a bank would remain solvent provided that a majority of its depositors do not try to take their money out at the same time. However, as a consequence of a public prophesy that the bank is going to fail, each depositor attempts to withdraw his funds and in the process of the resulting liquidity crisis, the bank does
indeed fail. Each individual can be fully rational and understand that if a “run on the bank” does not occur, it will indeed be solvent. Nevertheless, as a consequence of the public prophesy, each depositor decides rationally to attempt to withdraw his savings and the prophecy of bank failure is fulfilled. As we know, one institutional design used to offset this dysfunctional collective behavior is deposit insurance. There are of course others. ( THIS WAS THE EXAMPLE MENTIONED, AND IT IS THE REASON FOR DEPOSIT INSURANCE, AND IT WORKS IN PREVENTING A RUN. ONE OF THE SUGGESTIONS WHICH I BACKED WAS TO HAVE GOVERNMENTS EXPLICITLY GUARANTEE A MAJOR PORTION OF THE SYSTEM IN ORDER TO SLOW DOWN THIS RUN, WHICH IS JUST ANOTHER NAME FOR THE FLIGHT TO SAFETY. IN OTHER WORDS, THAT'S WHAT THE GOVERNMENT IS DOING NOW. THE TRICK IS FINDING THE RIGHT LEVEL OF BACKING, IN THE SAME WAY THAT THE FDIC DETERMINES THE AMOUNTS AND TERMS OF DEPOSIT INSURANCE )

"Improving technology and a decline in transactions costs has added to the intensity of that
competition. Inspection of Finnerty’s (1988, 1992) extensive histories of innovative financial products suggests a pattern in which products offered initially by intermediaries ultimately move to markets. For example: • The development of liquid markets for money instruments such as commercial paper allowed money-market mutual funds to compete with banks and thrifts for household savings. • The creation of “high-yield” and medium-term note markets, which made it possible for mutual funds, pension funds, and individual investors to service those corporate issuers who had historically depended on banks as their source of debt financing.
• The creation of a national mortgage market allowed mutual funds and pension funds to
become major funding alternatives to thrift institutions for residential mortgages. • Creation of these funding markets also made it possible for investment banks and mortgage brokers to compete with the thrift institutions for the origination and servicing fees on loans and mortgages.
• Securitization of auto loans, credit-card receivables, and leases on consumer and producer
durables, has intensified the competition between banks and finance companies as sources
of funds for these purposes. This pattern may seem to imply that successful new products will inevitably migrate from intermediaries to markets. That is, once a successful product becomes familiar, and perhaps after some incentive problems are resolved, it will become a commodity traded in a market. Some see this process as destroying the value of intermediaries. However, this “systematic” loss of successful products is a consequence of the functional role of intermediaries and is not dysfunctional. Just as venture-capital firms that provide financing for start-up businesses expect to lose their successful creations to capital market sources of funding, so do the intermediaries that create new financial products expect to lose their successful and scalable ones to markets. Intermediaries continue to prosper by finding new successful products and the institutional means to perform financial functions more effectively than the existing
ones, all made possible by the commodization of existing products and services.( I WOULD SAY THAT THE INTERMEDIARIES TOOK ADVANTAGE OF THE MARKET )

"Consider, for example, the Eurodollar futures market that provides organized trading in standardized LIBOR (London Interbank Offered Rate) deposits at various dates in the future. The opportunity to trade in this futures market provides financial intermediaries with a way to hedge more efficiently custom-contracted interest-rate swaps based on a floating rate linked to LIBOR. A LIBOR rather than a US Treasury rate-based swap is better suited to the needs of many intermediaries’ customers because their cash-market borrowing rate is typically linked to LIBOR and not to Treasury rates. At the same time, the huge volume generated by intermediaries hedging their swaps has helped make the Eurodollar futures market a great financial success for its organizers. Furthermore, swaps with relatively standardized terms have recently begun to move from being custom contracts to ones traded in markets. The trading of these so-called “pure vanilla” swaps in a market further expands
the opportunity structure for intermediaries to hedge and thereby enables them to create more customized swaps and related financial products more efficiently. ( I'M SURE THIS SEEMS NAIVE NOW, BUT IT IS IMPORTANT TO UNDERSTAND HOW THESE INVESTMENTS WERE SUPPOSED TO FUNCTION )

"A well-established legal and transactional infrastructure for swaps together with the enormous scale of such contracts outstanding51 set conditions for the prospective use of swaps and other contractual agreements to manage the economic risks of whole countries in a non-invasive and reversible fashion.52 Thus, countries can modify their risk exposures separately from physical investment decisions and trade and capital flow policies. This application of financial technology offers the potential for a country to mitigate or even eliminate the traditional economic tradeoff between pursuing its comparative advantages, which by necessity requires it to focus on a relatively few related activities and achieving efficient risk diversification, which requires it to pursue many relatively unrelated activities." ( AGAIN, IT SEEMS NAIVE, BUT IT'S HOW SWAPS WERE SUPPOSED TO WORK )

"We have framed and illustrated by examples the FSF approach to the design of financial systems.We conclude here with some observations connecting the design and implementation of a well-functioning financial system with the broader economic issues of promoting long-term economic growth ( TRUE ). Nearly a half century ago, Robert Solow’s fundamental work on the long-run determinants of economic growth concluded that it was technological progress ( I TEND TO AGREE ), not high rates of saving or population growth, that account for the vast bulk of growth. Subsequent studies have tried to reduce the unexplained residual by adding other measurable inputs. A large body of recent research work suggests thatwell-functioning financial institutions promote economic growth( WE DON'T HAVE THOSE ). These conclusions emerge from cross-country comparisons,53 firm-level studies,time-series research,55 and econometric investigations that use panel techniques.56 And in their historical research, North (1990), Levine (2002), Neal (1990), and Rousseau and Sylla (2003) have all concluded that those regions—be they cities, countries, or states—that developed the relatively more sophisticated and well-functioning financial systems were the ones that were the subsequent leaders in economic development of their times. An integrated picture of these findings suggests that in the absence of a financial system that can provide the means for transforming technical innovation into broad enough implementation, technological progress will not have a significant/substantial impact on the economic development and growth of the economy. Therefore, countries like China or even Japan, that need to undertake restructuring of their financial systems, should consider not only their short-run monetary and fiscal policies, and not only the impact of these policies on national saving and capital formation, but also how changes in their financial institutions will affect their prospects for long-term economic development ( I AGREE ). But substantial changes and adaptations in the institutional implementation will be necessary in different countries. There are at least two reasons:
(1) national differences in history, culture, politics,
and legal infrastructure( I AGREE ), and (2) opportunities for
a country that is in the midst of restructuring its
financial system to “leap frog” the current best practices
of existing systems by incorporating the latest
financial technology in ways that can only be done
with “a clean sheet.”( I AGREE )
There is not likely to be “one best way” of providing financial and other economic functions( VERY TRUE ). And
even if there were, how does one figure out which one is best without assuming an all-knowing benevolent ruler or international agency? One must take care to avoid placing the implementation of all economic development into one institutionally
defined financial channel( TRUE ). Fortunately, innovations in telecommunications, information technology, and financial engineering offer the practical prospect for multiple channels for
the financing of economic growth. Multiple channels for capital raising are a good idea in terms of
greater assurance of supply at competitive prices. They also offer the prospective benefits of competition to be the best one in a given environment at a given point in time (TRUE ).
Much of the traditional discussion of economic policy focuses on its monetary, fiscal, currency
management aspects and on monitoring capital and trade flows. These are important in the short
run, and thus also in the long run, in the sense that one does not get to the long run without
surviving the short run. However, if financial innovation is stifled for fear that it will reduce the
effectiveness of short-run monetary and fiscal policies (or will drain foreign currency reserves), the consequences could be a much slower pace of technological progress( THIS WOULD NOT BE GOOD ). Furthermore, long-run policies that focus on domestic saving and capital formation as key determinants of economic growth do not appear to be effective( BUT THEY ARE IMPORTANT ). Policies designed to stimulate innovation in the financial system would thus appear to be more important for long-term economic development ( I AGREE )."

Okay. Read this paper. It's like a Rorschach Test. If you agree with me, it will make sense, and you will likely find these investments like Derivatives to have positive value, and look elsewhere for the cause of our current crisis. If you find the paper naive and silly now, in light of current events, then the complexity and product argument probably works for you.

"There is a real danger that this action plan - within such a short time frame - can actually make the global downturn dramatically worse."

Simon Johnson on The Baseline Scenario on the G2o statement:

"Initial reactions to the G20 summit are fairly positive, in the sense that the communique and associated press conferences conveyed (a) there was no open acrimony, (b) the body language was broadly supportive of countercyclical policies, and (c) there may now be a serious international regulatory agenda.

None of this is really new and it could all have been arranged by finance ministers (probably over the telephone), but I agree there is some useful symbolism in having heads of industrialized and emerging market governments convene for the first time (ever?) on these kind of issues."

This seems correct.

"But there is, unfortunately, another way to read the communique - as a government or international official, for whom this text really is a set of instructions to be implemented. The whole first part of the document is generic and definitely not new, so - as an official - one’s eye skips through that quickly. The real issue is the deliverables in the plan of action, with a pressing deadline at the end of March (this is pretty much like saying “do it tomorrow” to an official). This is where we - an official reader is thinking - must concentrate our immediate attention and efforts. And most of these specific actions are about tightening regulation on and around credit, or beginning processes that definitely point towards many dimensions for this kind of tightening - accounting standards, hedge funds, risk disclosures, financial sector assessments, credit rating agencies, risk management and stress testing models, international standard setters, sanctions for misconduct, reporting to supervisors in different countries, and more."

But I didn't see any specifics.

"But we are still not out of this crisis. And tightening regulations quickly in the midst of a worldwide credit crunch is one good way to make sure that credit contracts further and faster. Lending standards naturally tighten in a crisis; the issue to address going forward is how to prevent standards from loosening too much in the next boom - but this is at least several years down the road. I’m in favor of starting early, but I do not like precipitate action just because you want to look busy and you could not agree on the more pressing issues, such as fiscal policy, support for the IMF, shoring up the eurozone, and so on.

It is true that one (among many) of the stated principles is: “Mitigating against pro-cyclicality in regulatory policy.” But that is a general statement that is not mapped into operational requirements - except that the IMF and FSF should work together on this, which is a good way to make sure it doesn’t happen. What officials have to deliver on, by the end of March, is substantive progress with regards to tougher and tighter regulation of credit. There is a real danger that this action plan - within such a short time frame - can actually make the global downturn dramatically worse."

Based on the document, I wouldn't worry. It isn't clear that they can agree on anything. But point well taken. Regulation in a crisis is worrying on any number of fronts, not the least of which is making the situation far worse.

G-7 Finance Ministers and Central Bank Governors Plan of Action

Via Across The Curve:

October 10, 2008
HP-1195

G-7 Finance Ministers and Central Bank Governors Plan of Action

Washington-- The G-7 agrees today that the current situation calls for urgent and exceptional action. We commit to continue working together to stabilize financial markets and restore the flow of credit, to support global economic growth. We agree to:

1. Take decisive action and use all available tools to support systemically important financial institutions and prevent their failure.
2. Take all necessary steps to unfreeze credit and money markets and ensure that banks and other financial institutions have broad access to liquidity and funding.
3. Ensure that our banks and other major financial intermediaries, as needed, can raise capital from public as well as private sources, in sufficient amounts to re-establish confidence and permit them to continue lending to households and businesses.
4. Ensure that our respective national deposit insurance and guarantee programs are robust and consistent so that our retail depositors will continue to have confidence in the safety of their deposits.
5. Take action, where appropriate, to restart the secondary markets for mortgages and other securitized assets. Accurate valuation and transparent disclosure of assets and consistent implementation of high quality accounting standards are necessary.

The actions should be taken in ways that protect taxpayers and avoid potentially damaging effects on other countries. We will use macroeconomic policy tools as necessary and appropriate. We strongly support the IMF's critical role in assisting countries affected by this turmoil. We will accelerate full implementation of the Financial Stability Forum recommendations and we are committed to the pressing need for reform of the financial system. We will strengthen further our cooperation and work with others to accomplish this plan.

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Again, I think we're there.