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  • Soros To Create New Think-Tank to Rethink Field of Economics

    George Soros announced earlier this week that he is launching a new think-tank which will be tasked with, in the words of Alan Rappeport of the Financial Times , "reconceiving the field of economics." And Soros explained his goal for the Institute of New Economic Thinking (INETT) to Rappeport's FT colleague, Chrystia Freeland: There’s been a pretty widespread recognition by professionals that something is fundamentally wrong in the prevailing doctrine about financial markets, that you need a new understanding that this whole idea of efficient market hypothesis, rational expectations theory, is totally devoid of reality, and so there is need for new thinking. I’m, of course, one of the protagonists that are putting forward a different alternative, but there are others and I think these alternatives need to be developed. I feel now sufficiently confident that I’m ready to also act as a financial sponsor for this Institute, which will actually develop the alternative. Soros has been lecturing all this week at the Central European University , in his native Hungary. In Tuesday's lecture, he laid out his thinking for the new think-tank (you can watch the relevant excerpt here ), but the series goes well beyond the financier's views of today's crisis. The Financial Times has made video of all of the lectures available here .

  • NY Fed Chair on the Root Causes of the Crisis and Potential Value of Contingent Capital

    William C. Dudley , President and Chief Executive Officer of the New York Fed , spoke yesterday at the Institute of International Bankers. Dudley shared his views on how to strengthen the financial system. He started by outlining what he sees as the basic cause of the crisis: Regulators and market participants failed to fully appreciate the degree to which the various aspects of our financial system are interconnected, and to foresee what those tight linkages would mean for market function when even one reasonably large institution—let alone many—became distressed. We also did not fully appreciate the strength of the amplifying mechanisms that were built into our financial system; the consequence of which was to exacerbate the boom on the way up and worsen the bust on the way down. Contributing to these pro-cyclical dynamics were inadequate incentives for firms to curb their risk-taking and to more effectively manage the risks they did face. The inadequate level of transparency and disclosure, particularly in the market for structured products, were also important in making the financial system more fragile and vulnerable to crisis and in increasing the degree of uncertainty and contagion once the crisis was underway. Dudley went on to outline a whole set of measures that might be taken to avoid the systemic risk that was central to the crisis. Among the more interesting ideas he discussed was the notion of introducing contingent capital instruments. These would be "debt instruments in “good” states of the world, but would convert into common equity at pre-specified trigger levels in “bad” states of the world," Dudley told the audience. Consider the advantages that such an instrument would have had during this crisis. Rather than banks clumsily evaluating whether to cut dividends, raise common equity and/or conduct exchanges of common equity for preferred shares and market participants uncertain about the willingness and ability of firms to complete such transactions and successfully raise new capital, contingent capital would have been converted automatically into common equity when market triggers were hit. If these contingent capital buffers were large, which they could be because the cost of these instruments should not differ much from straight debt, then the worst aspects of the banking crisis might have been averted. If shareholders had faced the potential of automatic and substantial dilution, they may have demanded better risk management and disclosure during the boom. If common equity had been automatically bolstered during the early part of crisis, investors would have been much less concerned about the risk of insolvency. Counterparty risk concerns would have been much less significant—potentially short-circuiting one of the important amplifying mechanisms of the crisis. Such instruments could have reduced the likelihood of failure of large, systemically important institutions, reducing the significance of the “too big to fail” problem and its associated moral hazard problems. Read the full speech here . (Hat tip to Mark Thoma for linking to the speech at Economists View ).

  • Stiglitz on International Monetary and Financial System Reform and the Too Big To Fail Problem

    Joseph E. Stiglitz , Bert Koenders , and Jose Antonio Ocampo discussed possible reform of the international monetary and financial system at the Carnegie Council on September 30. Stiglitz chaired the UN Commission of Experts on Reforms of the International Monetary and Financial System, and he told the audience that the multi-national commission's findings "provide a deeper analysis of the causes of the crisis and a long-term agenda of what to do about it than, for instance, what has come out of the G-20 communiqués and reports." One of the commission's concerns over the response to the global economic crisis, in the United States in particular, is consolidation in the banking sector. As Stiglitz said at the Carnegie Council: The problem of too-big-to-fail banks has become much worse since the beginning of the crisis. While we're making some strides in trying to improve things, we've made some things much worse. It's worse because we have bigger banks, more concentration, but also because we've increased the moral hazard problem. We've introduced in many countries around the world a new concept that never had any role in economics before: banks that are too big to be financially resolved, where you protect the bondholders and shareholders as well as the institution and the depositors. Here is an excerpt from the panel discussion: To watch the full session, click here . And you can read the Report of the Commission of Experts of the President of the United Nations General Assembly on Reforms of the International Monetary and Financial System here .

  • Oliver Williamson on Nobel Recognition: 'Organziation Matters'

    Earlier we shared a video of Elinor Ostrom discussing her research . It is only appropriate that we give Oliver Williamson a little face time on The Watch. In this video of the Cal-Berkeley press conference held to congratulate Williamson on receiving the Nobel Memorial Prize, the honoree says that the award confirms the central idea of his work--"organization matters." (skip to 12:00 in to get past the introductions)

  • Nobel Memorial Prize in Economics Goes to Two Americans for Economic Governance Work

    The Royal Swedish Academy of Sciences has awarded the 2009 Nobel Memorial Prize in Economics to two Americans for their work on economic governance research, and how important economic decisions are made "outside of markets – within households, firms, associations, agencies, and other organizations." Elinor Ostrom of Indiana University is the first woman to ever receive the prize. She is being recognized for her work on the management of "common property," a timely subject of study given the attention to finding solutions to the effects of climate change. Ostrom's research has looked at how users of common property might themselves best manage that use, as opposed to outside or government oversight. From the announcement: It has frequently been suggested that common ownership entails excessive resource utilization, and that it is advisable to reduce utilization either by imposing government regulations, such as taxes or quotas, or by privatizing the resource. The theoretical argument is simple: each user weighs private benefits against private costs, thereby neglecting the negative impact on others. However, based on numerous empirical studies of natural-resource management, Elinor Ostrom has concluded that common property is often surprisingly well managed. Thus, the standard theoretical argument against common property is overly simplistic. It neglects the fact that users themselves can both create and enforce rules that mitigate overexploitation. The standard argument also neglects the practical difficulties associated with privatization and government regulation. Oliver Williamson , of the University of California, Berkeley, is being recognized for his work in teaching us "to regard markets, firms, associations, agencies, and even households from the perspective of their contribution to the resolution of conflict." In the early 1970s, Oliver Williamson argued that hierarchical organizations sometimes dominate markets because they provide a cheaper way to resolve conflicts. If two employees quarrel about the allocation of tasks or the distribution of revenues, a chief executive is entitled to decide. In a market, on the other hand, negotiations have to continue until both parties agree. Haggling costs can be substantial, and there is no guarantee that the final agreement will be either immediate or efficient. This argument may seem to suggest that all transactions should take place in a single giant firm. But this is clearly not an accurate description of the world as we know it. The last decade has witnessed just the opposite. Considerable outsourcing has taken place, sometimes by merely selling part of a company, while activities continue in all units much as before. That is, outsourcing creates a market transaction replacing an internal transaction. In order for this kind of outsourcing to make any sense, there must be drawbacks associated with hierarchical organization too. It is interesting to note that both economists were born during the Great Depression. Read the full announcement from the Royal Swedish Academy here .

  • The Push For the Consumer Financial Protection Agency and the Push-Back From the US Chamber of Commerce

    The White House is pushing Congress to create a Consumer Financial Protection Agency . The creation of the new agency would be part of the Obama administration's larger package of financial regulatory reforms. And Austan Goolsbee of the president's Council of Economic Advisors says the new regulations will "re-establish rules of the road" as they apply to consumers: The US Chamber of Commerce has been leading the charge against the creation of the CFPA. The Chamber's David Hirschmann called it "an unnecessary big government solution," last month, after a revised version of the the CFPA proposal was announced. Click here to read the Chamber of Commerce's list of objections to the CFPA. The battle lines look familiar to University of South Carolina professor of history Lawrence Glickman . In a guest post at Baseline Scenario , Glickman, author of Buying Power: A History of Consumer Activism in America , sees the roots of today's opposition to the CFPA in the push against the creation of a Consumer Protection Agency in the 60s and 70s. Read Consumer Protection Redux: The Lessons of History here .

  • Federal Reserve Pushes New Rules to Protect Credit Card Users

    The Federal Reserve is proposing new rules to strengthen Truth in Lending regulation. And , according to the Fed, the new rules would: Protect consumers from unexpected increases in credit card interest rates by generally prohibiting increases in a rate during the first year after an account is opened and increases in a rate that applies to an existing credit card balance. Prohibit creditors from issuing a credit card to a consumer who is under the age of 21 unless the consumer has the ability to make the required payments or obtains the signature of a parent or other cosigner with the ability to do so. Require creditors to obtain a consumer's consent before charging fees for transactions that exceed the credit limit. Limit the high fees associated with subprime credit cards. Ban creditors from using the "two-cycle" billing method to impose interest charges. Prohibit creditors from allocating payments in ways that maximize interest charges. Read the Fed's release here .

  • Lacking Hope in Regulatory Reform

    We're past the one-year anniversaries of the fall of Lehman Brothers and the near collapse of AIG, but the question over what we have learned from the crisis is bothering more than a few big economic thinkers and policy makers. Emma Bonino is Vice President of Italy's senate, and she concludes in today's Financial TImes that global leaders seem to have learned very little: As the saga of platitudes on the financial crisis comes to an end, hard questions now lie on the hands of world leaders. And the number of hands has expanded, with the Group of 20 leading nations set to replace the G7 and G8 as the hub of global economic co-operation. Economic giants, such as China, India and Brazil, will now have a voice in shaping world finance. This, of course, illustrates that decentralisation of economic power in the new world order is an unstoppable development, which may prove to be a positive one if the newcomers behave as responsible stakeholders. But will all this summitry really make a difference? With the benefit of hindsight we can see the flaws in the financial system that allowed the collapse of Lehman Brothers to bring the global economy to its knees. But will we be able to say we wised up and put in place a better financial system? Unlikely. So far, all we have really done is change the decision-making body, while the causes and symptoms of the financial crisis remain unchecked. Small and medium-sized banks continue to file for bankruptcy at a worrying pace. We still have not curbed the noxious behaviour of big banks: their social and political importance was enhanced more than scrutinised by the financial fallout after the Lehman disaster. “No more Lehmans” was the motto, cried both by banks and the public. The toxic combination of bank subsidies and bankers’ bonuses have socialised losses and privatised gains. Read What did we really learn from the financial crisis here . In the Washington Post, Simon Johnson and James Kwak argue that if we learned anything from the events of a year ago, the time to act is now. "The next couple of months will be crucial in determining the shape of the financial system for decades to come," they write. And they don't hold a lot of confidence in the Obama administration's ability to push through reform: We have criticized the administration's reform proposals, in particular for not going far enough to address the problem of financial institutions that are "too big to fail." But we support much of what was in the original package, particularly the CFPA and increased regulation of complex financial products. The question now is how hard Obama and Geithner will fight for it. Financial regulation, like health care reform, has entered the phase where speeches and proposals matter less than arm-twisting and horse-trading on Capitol Hill. With health care, President Obama attempted to go over the heads of Congress, directly to the American people. With financial regulation, that is no longer an option, given the extent to which it has faded from public consciousness. Read It's Crunch Time: The Fight to Fix the Financial System Comes Down to This here .

  • Ratings Agencies on the Stand: SEC, Congress and Possible Changes in Ratings Oversight

    On Thursday Eric Kolchinsky will testify about ratings-firm reform before the House Committee on Oversight and Reform. The former analyst for Moddy's (he left the firm last week after being suspended) is likely to become a bit of a star witness for those who are concerned that ratings agencies have been boosting ratings. The Wall Street Journal reports today that Kolchinsky told Congressional investigators that Moody's continues to issue inflated ratings of "complex debt securities." Last week the Securities and Exchange Commission approved a set of new rules designed to give the commission more oversight of credit ratings agencies. If Kolchinsky's testimony is well received, it could mean Congress pushes for further regulation of the agencies. The New Yorker 's James Surowiecki is among those who believes the credit agencies share some responsibility for the housing bubble by giving high ratings to "dubious mortgage-backed securities." Surowiecki writes, that while the SEC's move last week was a positive step in that it helps in resolving conflicts of interest... ...there’s a much bigger problem, which is that, even though nearly everyone knows that the agencies are compromised and exert too much influence, the system makes it impossible not to rely on them. In theory, of course, the mere fact that a rating agency says a particular bond is AAA (close to risk-free) doesn’t mean that investors have to buy it; the agencies’ opinions should be just one ingredient in any decision. In practice, the government’s seal of approval, coupled with those regulatory requirements, encourages investors to put far too much weight on the ratings. According to a recent paper on the subject by the academics Darren Kisgen and Philip Strahan, that’s true even when the agency doing the rating doesn’t have a long track record. During the housing bubble, investors put a huge amount of money into AAA-rated mortgage-backed securities—which would have been fine had the rating agencies’ judgments been sound. Needless to say, they weren’t. Despite subprime borrowers’ notoriously shaky finances, the agencies failed to allow for the possibility that housing prices might fall sharply. Read Ratings Downgrade here .

  • Lehman Brothers Compliance Chief Tells Complinet That Faith in Models Ultimately Doomed Company

    The financial pages are abuzz over the anniversary of the the collapse of Lehman Brothers , and President Obama is going to mark the occasion by speaking about Wall Street on Wall Street. He is expected to address regulatory reform and the government's continuing efforts to drive economic recovery. As for Lehman Brothers , David DeMuro provides a particularly interesting perspective. DeMuro was Lehman's head of compliance and regulation. Earlier this summer he spoke at Complinet , a firm specializing in compliance issues. And DeMuro stressed that the issues at Lehman were not unique to that firm. He places a lot of blame for the collapse on a sort of bubble euphoria. He and others may have seen red flags, particularly with mortgage subsidiaries, but the firm did not change its ways because of what DeMuro calls an "almost religious belief in the veracity of the models that comforted a lot of people": The Great Crash of 2008: An Insider's View of a Global Economy in Crisis and the Regulatory Failures from complinet on Vimeo .

  • Bllomberg: SEC's Mary Schapiro 'In Conversation'

    Securities and Exchange Commission Chair Mary Schapiro has a big task: to build up the public's trust in the SEC after the Bernard Madoff disaster, and myriad questions about what exactly happened during Bank of America's takeover/rescue of Merrill Lynch. In an interview with Judy Woodruff for Bloomberg , Schapiro says that the SEC is already doing a better job of catching other "Madoffs." She also says the SEC has replaced a lot of its senior leadership, and is poised to run more smoothly:

  • Must Read: Sheila Bair NYT Op-Ed on Super-Regulator Idea

    In today's New York Times , FDIC Chair Sheila Bair weighs in on the notion that the US needs one "super regulator" to oversee all financial entities. Bair says the Obama Administration is taking the right tack in tightening regulation, but that shifting to one single regulator would not provide the control that proponents of the idea suggest, and, in her eyes, would make the system more susceptible to some of the problems that sparked the current recession. But most importantly, she writes, it would threaten the US banking system in general, and harm small banks in particular: The principal enablers of our current difficulties were institutions that took on enormous risk by exploiting regulatory gaps between banks and the nonbank shadow financial system, and by using unregulated over-the-counter derivative contracts to develop volatile and potentially dangerous products. Consumers continue to face huge gaps in personal financial protections. We also lack a credible method for closing large financial institutions without inflicting severe collateral damage on the economy. The creation of a single regulator for all federal- and state-chartered banks would not address these problems. Rather, it would endanger a thriving, 150-year-old banking system that has separate charters for federal and state banks. Within this system, state-chartered institutions tend to be community-oriented and very close to the small businesses and consumers they serve. They provide loans that support economic growth and job creation, especially in rural areas. Main Street banks also are sensitive to market discipline because they know that they’re not too big to fail and that they’ll be closed if they become insolvent. Read The Case Against a Super-Regulator here .

  • Cleveland Fed Proposal for Regulating 'Systemically Important Financial Institutions'

    A group of researchers at the Cleveland Fed have a new idea for how to deal with the so-called "too big to fail" institutions. In language more suited to a Fed researcher, James Thomson --Vice President and Financial Economist at the Cleveland Fed--calls them " Systemically Important Financial Institutions ," and he writes in a paper that the first step is better defining these institutions: The purpose of creating a practical definition of systemic importance is to enable supervisors to discipline systemically important financial institutions. Understanding the nature and causes of systemic importance is the foundation for creating regulations, supervisory policies, and infrastructure that will rein in the associated systemic risk; in some cases, doing so sufficiently mitigates an institution’s potential systemic impact so that it would no longer be considered systemically important. Because any two firms could be deemed systemically important for unrelated reasons, a one-size-fits-all designation such as “too big to fail” is inadequate. Consequently, the approach taken here is to propose a means of classifying systemically important financial institutions (SIFIs). And the economists at the Cleveland Fed tout a three-tiered approach to regulating SIFIs. You can more about the approach here , and watch this helpful Drawing Board video: (Hat tip to Caitlyn Kenney at Planet Money)

  • Schumer Targets High-Frequency Trading

    Before the August recess, Sen. Charles Schumer (D-NY), was pushing for an end to " High Frequency Trading ," saying, in a letter to Securities and Exchange Commission chair Mary Schapiro : If the SEC fails to curb this practice, I plan to introduce legislation in the U.S. Senate to prohibit the use of flash orders in connection with optional pre-routing programs in order to ensure that trading in U.S. public capital markets is fair and transparent for all market participants. So what exactly is this practice that has Sen. Schumer so concerned? Marketplace 's Paddy Hirsch explains in this Whiteboard video: High-frequency trading from Marketplace on Vimeo .

  • Hedge Funds' Internal Controls

    Hedge funds have had a very good year so far--their best first-half year in a decade, according to Reuters . And while hedge fund managers argue that their hands are clean with regard to the financial crisis, there is plenty of reason to expect further regulation of these funds, in the US and in Europe . But Wharton Professor Gavin Cassar and University of Chicago Booth School of Business professor Joseph Gerakos examined the management of hedge funds, and came to the conclusion that investors do hold the power to demand "internal controls" to prevent fraud. And a couple of their findings may seem counterintuitive. Managers' fees, where the hedge fund is set up, and how old it is matters, but maybe not in the way you expect: Using a proprietary database of due diligence reports, we find that funds domiciled offshore are more likely to adopt stronger control mechanisms that decrease the likelihood of fraud and financial misstatements, and are more likely to use reputable outside service providers and incorporate stricter authority over the transfer of funds. We also find that internal controls vary systematically by fund leverage and fund age, and whether the fund pursues a short selling investment strategy; consistent with agency costs and the protection of proprietary information explanations, respectively. With respect to internal control outcomes, managers of funds that have restated performance receive lower management fees. Further, we find a positive association between internal controls and performance based fees, which is consistent with investors protecting against manipulated reported returns due to inadequate internal controls. Here's Cassar describing the authors' findings for Knowledge@Wharton : You can read Determinants of Hedge Fund Internal Controls and Fees here .
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