Sallie Krawcheck, past head of Merrill Lynch and Smith BarneyThis post originally appeared on LinkedIn. Follow Sallie on Linkedin
Are we beating a dead whale? Last week’s Senate hearing on JP Morgan $6 billion “London Whale” trading losses captured its fair share of media attention. But even with the compelling theatre this provided, the hearing’s most significant contribution may not be the particulars of the loss; it could instead be a renewed discussion on the safety of the financial system and the large banks.
Here are some of the significant questions that have not been fully unanswered:
Do banks and their regulators truly have their arms around the risks they are taking? It is awfully clear that we as an industry did not going into the crisis. Have banks gotten smarter – or smarter enough – about risk, and have their risk management systems improved enough? What does the London Whale loss indicate about this?
If banks are going to make mistakes, do they have enough capital to absorb them? Is the upcoming Basel 3 capital regime simply too flawed to be effective? Even before we adopt it, we know a number of Basel 3’s flaws: sovereign debt treated as risk-free (uh-oh), banks using their own risk models to determine capital weightings, continued reliance on rating agencies, and Basel’s significant complexity. Is it “good enough,” or should it be overhauled before adoption?
If Basel is flawed, how about the old-school leverage ratio? If a minimum leverage ratio is a backstop, does it provide enough of a cushion? The 8% leverage ratio (equity / assets) that a number of respected regulatory heavyweights are calling for is much better than the 2% of some large financial institutions going into the downturn. But, by definition, it means that losses of 8% of assets wipe out equity (and banks certainly suffer bank runs well before that). Is that enough of a capital cushion? Does it protect against a 100-year flood, or just a 10-year flood??
Are the banks still too complex to be effectively monitored by Boards and regulators? Do their management teams have to be super-human smart to manage them or can they be run by mere mortals?
And are we comfortable that businesses of this complexity carry this level of financial leverage? Asked yet again, do the capital cushions provide enough margin for error for these systemically important institutions, since mistakes can have far greater impact than just on the shareholders?
Has senior bank executive compensation changed enough to disincentivize risk taking? This is not an issue of lowering compensation levels, but making sure that the structure of compensation is incenting the desired behaviour. Are claw-back provisions and the longer vesting of equity enough? Or should there be a move toward paying in less-risk-encouraging instruments, such as bank debt?
How can the bank Boards more effectively manage these institutions? The Office of the Comptroller of the Currency recently determined that 17 of the 19 large national bank Boards do not provide effective oversight of their banks. How can this be improved? It’s likely not as easy as replacing Board members, since there has been a great deal of turnover since the crisis. Should the Chairman and CEO roles be split? Should board sizes be reduced, to improve their sense of personal accountability? Should Boards commit significantly more of their time to the banks?
Would breaking up the large banks make a difference? There has been a good deal of discussion on this. It could certainly make each individual entity less complex, but it wouldn’t necessarily make them better capitalised and thus may not necessarily make the system substantially safer.
Can we please take some action on making money funds safer? This does not impact many of the large banks directly. But the structure of money funds today – a huge market with implicit guarantees to individual investors…with no capital cushion in case of loss…for products that can lose principal…that has been subject to panics in the past – can be a risky combination, to say the least.
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