How to retire the old ‘Concorde’ financial system for good

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Best known for his accurate warnings of impending doom in the global economy over the last few years, Nouriel Roubini now opts to deliver some constructive criticism about how to permanently fix the financial system.

His summary advice to global banking regulators: Forget the idea of having the equivalent of a Concorde supersonic plane for a financial system; aim for one that is ‘somewhat slower but more stable.’

The New York University economics professor, writing on his Global EconoMonitor blog over the weekend with colleagues Viral Acharya and Matthew Richardson, suggests four major alterations to the system to reduce risk and avoid a repeat of the catastrophe of the last two years:

--- Change the pay structure for traders and other ‘profit centers’ at major financial institutions to provide bonuses for good performance but also clawbacks of pay for bad performance. The basic idea: Make sure traders etc. know there will be a penalty for taking extreme risks, beyond just losing one’s job.

--- Charge institutions appropriately for ‘socialized risks -- deposit insurance, too big to fail, temporary loan guarantees and the like,’ so that the net effect is to ‘discourage size and risk distortions’ in the system. In other words, stop rewarding bigness that could destabilize the entire system.

Roubini, Acharya and Richardson note: ‘Financial institutions will attempt to exploit government guarantees if that is in the interest of shareholders. That is what they are paid to do. So it is imperative to price the guarantees right,’ which means governments should junk any one-price-fits-all approach.

--- Create a regulatory authority capable of quantifying the systemic risk posed by large financial institutions and with the power to manage their failure.

--- Enforce better transparency of over-the-counter derivatives and off-balance-sheet transactions, including credit default swaps.

‘The recent meeting of the Group of 20 went some way to set the system to rights,’ Roubini, Acharya and Richardson write. ‘First, there seems to be general agreement that regulators should work together on a core set of principles. Without such an agreement financial institutions will be able to cherry-pick their jurisdictions. Second, at least from our point of view, the G20 has homed in on most of the important threshold issues, especially the focus on systemic risk, opacity and compensation within the financial system.

‘We think the issues of implicit and explicit government guarantees (the second point above) warrant far more air-time at future G20 meetings. A solution as simple as pricing these guarantees at the appropriate market rate will help solve the problem, as higher fees for higher systemic risk and leverage will organically lead these institutions to lower their risk profiles.’

What about the potential for regulators to go overboard with reforms and stifle financial innovation?

Roubini, Acharya and Richardson respond: ‘The goal is not to have the most advanced financial system, but one that is reasonably advanced and robust. That is also what we seek in other areas of human activity.’

Drawing a parallel between the Concorde and the high-speed financial system that developed over the last 20 years, the academics note that Concorde aircraft finally were retired in 2003 after 27 years in service and ongoing controversy over the program’s complexity and cost vs. its benefit of supersonic flight.

So ‘we do not use the most advanced aircraft to move millions of people around the world’ anymore. ‘We use reasonably advanced aircraft whose designs have proved to be reliable.’

-- Tom Petruno