Fixing risk management at banks more complicated than fixing regulation

Correcting the risk management practices at banks is far more complex than correcting the financial regulatory structure, Larry Cordell, vice president of the Risk Assessment, Data Analysis and Research (RADAR) unit at the Federal Reserve of Philadelphia said at the Federal Reserve Bank of Chicago’s 48th Annual Conference on Bank Structure and Competition. Cordell, who discussed the paper: Collateral Damage: Sizing and Assessing the Subprime CDO Crisis, said that fixing the regulatory structure is largely done through the establishment of his group to monitor the financial markets, annual stress tests for the nation’s largest banks and some of the rules in the Dodd-Frank Act.
However, fixing risk management practices within banks requires cultural shifts and changes that have to come from within the organizations, Cordell said, adding: “Compensation practices incentivize risk-taking; these [practices] have not been changed.

Failures in Risk Management Primary Culprit in 2007 Financial Crisis: Cordell

Failure to recognize the over-concentration of risk in collateralized debt obligations (CDOs) was the major contributing factor in the subprime crisis, according to Larry Cordell, vice president of the Risk Assessment, Data Analysis and Research (RADAR) unit at the Federal Reserve of Philadelphia who discussed the issue at Federal Reserve Bank of Chicago’s 48th Annual Conference on Bank Structure and Competition.  Cordell noted a 2005 comment from Warren Buffett, who called CDOs “financial weapons of mass destruction.” Cordell said that 42 percent of the financial crisis was related directly to the CDOs. There were several issues – the products were highly leveraged, any proceeds were used to purchase more CDOs, and the entities buying and selling the products largely didn’t understand them.

GSEs Inefficient, Contributed to Financial Crisis: Researcher

Stuart Gabriel, director of the Ziman Center for Real Estate at UCLA, said that the government sponsored entities, Fannie Mae and Freddie Mac, have provided real little value in the mortgage market and should be transitioned out of the business.
Stuart, speaking at the Federal Reserve Bank’s 48th Annual Conference on Bank Structure and Competition, said that only about half the 30-40 basis point GSE funding advantage was passed to consumers in lower rates; GSE affordable housing loan purchase programs were of limited efficacy in achievement of homeownership; the GSEs had a destabilizing influence on mortgage markets and served to exacerbate the subprime boom while also crowding private investors out of the mortgage market.

Former U.S. Comptroller Says Bank Supervision Must Use Good Judgment Be Flexible

Eugene Ludwig, former U.S. Comptroller under President Clinton and founder and CEO of Promontory Financial Group, said that financial services regulations must be flexible enough to protect against failures and abuses in financial institutions without being too restrictive while also being adaptable enough to evolve with the industry. Ludwig, speaking before a lunch gathering at the Federal Reserve Bank of Chicago’s 48th Annual Conference on Bank Structure and Competition, said that good regulation requires good judgment. “There is a tradeoff between flexibility and control,” Ludwig said. “A regulatory system that relies entirely on discretion can become scattershot; supervisory outcomes can become widely divergent, and in some cases, unfair. On the other hand, a system that relies entirely on enumerated rules will be too complex, it will either try to account for every negative eventuality and become too dense to implement, or it will fail to adapt to new problems in new forms. Either extreme can create a level of government intervention that runs in the face of free enterprise and the discipline of the free market.”

Former U.S. Comptroller Says Bank Supervision, Supervisors Must Improve

Eugene Ludwig, former U.S. Comptroller under President Clinton and founder and CEO of Promontory Financial Group, said improvements in the bank supervisory system and among the people working in the system are essential for an improved banking system. Ludwig, speaking before a lunch gathering at the Federal Reserve Bank of Chicago’s 48th Annual Conference on Bank Structure and Competition, said: “Broader supervisory discretion should come with greater accountability, and specific expectations for examiners and agency heads. We should produce regular ‘supervisory report cards’ measuring performance throughout the supervisory process, including the efficiency of bank regulation. These would go beyond current ‘material loss reviews’ and gauge the quality of financial oversight before a failure occurs. “We should also provide far more professional opportunities for supervisors. The apprenticeship area is long over. Supervision should have the same stature as law and business, with its own professional criterion and independent body of literature. Universities should be places where government and the private sector come together to exchange knowledge about what regulation is, can be and should be.”

Restructured Mortgage Pipeline Needs Diverse Elements: Fed Economists

Following the recent financial crisis, the mortgage pipeline, from the mortgage origination to the sometimes multiple levels of mortgage investors, to homeowners needs to be rebuilt as there are now leaking holes in the old model, many experts agree.
In preliminary research that examines this problem, Federal Reserve economists Wayne Passmore and Diana Hancock concluded that any updated mortgage pipeline needs to include elements from insurance to statistics. They presented their findings at the Federal Reserve Bank of Chicago’s 48th Annual Conference on Bank Structure and Competition.
They recommended that the new mortgage pipeline include:

• Catastrophic insurance to bring in guarantee-sensitive investors and create liquidity in secondary market for mortgages, and allow for hedging of interest rate risks.

• A national mortgage database that allows mortgage market participants―bankers, investors in subordinated mortgage-backed securities, investors in covered bonds, private mortgage insurance providers, and the government insurer―to measure and assess their risks.

• Subordination structure of liens/ PMI requirement to ensure homeowner, PMI providers (if applicable), and private-sector securitizers / covered bond issuers bear losses before the government, which only bears “tail-risk.”  Hence, these providers of mortgage financing would have an incentive to price their risks.

• Government underwriting standards / standardization to facilitate liquidity in secondary market for subordinated MBS.

• A limited government role because the provision of tail-risk insurance ensures mortgage credit availability throughout the housing cycle.

• Subordination structure of liens that brings private capital/homeowner equity into the “first loss” position (as well as “second loss” and “third loss” positions).