This article was last updated on September 27
A sign of America’s declining influence in controlling world financial markets was signaled by the fact that unprecedented Federal Reserve and Treasury actions over the last few months was not enough to calm financial markets that went into free fall last week. It wasn’t until a coordinated global rescue, orchestrated by EU members over the weekend, that global markets and the Dow finally found some confidence to move upwards in a significant manner (up 11% on Monday). In the past, it was up to America to set and lead the course for global financial markets, but recent events could augur a future in which the rest of world will not and does not want America to control the financial system. Perhaps it is better that way. Just like one company should not be “too important to fail and bring ruin to all”, so to should the influence of one country be limited.
The Global rescue plan basically guaranteed deposits and injected massive amounts of cash (liquidity) into financial markets. The 15 Euro-zone countries agreed to a plan that will guarantee loans between banks through 2009 and allow governments to buy stock in distressed financial companies. America has announced it will follow a similar plan. The ECB, the Bank of England and the Swiss National Bank also announced they would lend unlimited amounts of dollars to banks. Germany made its own announcement of a $107 billion recapitalization plan. The Spanish government also agreed a package worth around $130 billion and. Italy set aside $27 billion to help banks.
The Global rescue plan still has a long way to go before it can be deemed a success, but it is a step in the right direction and the markets have shown their support. However, it only addresses the current financial crisis and for real long term structural reform these are some of the key steps I believe should be taken to ensure we do not end up in this financial quagmire again:
1. Global oversight of financial markets. One thing that has been confirmed with any doubt whatsoever by recent events is that we live in the age of extremely interconnected global financial markets, and as such a global regulator with sufficient authority is required to monitor market functions. This regulator would be compromised of representatives from all member countries central and federal banks, and take responsibility for ensuring the stability of the global financial system in conjunction with each countries financial regulatory bodies. This and other financial oversight could be spelled out in an updated Bretton Woods financial agreement, originally written in 1930, to reflect the new rules of the 21st century global financial system. However, I must stress that over regulation can be as bad as no regulation so a manageable balance must be struck between government oversight and the self-discipline of financial markets.
2. Global setting of minimum financial standards. A common set of global accounting standards should be set to determine the minimum disclosure required of exotic financial instruments/derivatives and their potential exposure. Companies should not be able to write and market securities where it is not clear what makes up the security and without providing information on the potential risk exposure to the various counter-parties and key stakeholders. Regulators should also reform “mark to market” accounting rules that force banks to book assets at the price they would get if they sold them now – which can be very detrimental in a illiquid or distressed market.
3. Tighten Home Lending and Borrowing Standards. From an American perspective, we have by far the most flexible credit markets in the world. Getting a home loan in this country was easier than anywhere else in the world; All you needed was a half decent credit score. Going forward, banks should be forced to look at not just the credit score, but at a person’s income, net assets and capability to repay the loan. By a similar token a clear mandate should be set for governing not just the banks that issue mortgages, but brokers and agents that sell these mortgages.
4. Limiting the influence that a single firm can have. One aspect of the current financial sector is the amount of consolidation taking place where stronger banks are taking over weaker banks at bargain basement prices. While this is necessary in the interim to restore stability in the sector, long term we should never let one company and it’s underlying asset base/exposure get so big it could place the country’s or world’s financial economy at risk. So once things are stabilized there should be a concerted effort to break up big banks, promote competition and force greater transparency.
5. Educating people on the basics of personal finance and debt. This is probably one of the most important things that should be done by the governments of all countries. The root cause of this crisis was people getting mortgages they could not afford. People blame financial companies, but if it wasn’t for the consumer demand they would not be able to sell all these exotic loans. My recommendation is that Personal Finance and Debt Management 101 be mandatory graded classes that everyone gets at school and also for first time homeowners. It is only through education and awareness that future generations can avoid repeating this whole mess again.
6. Controlling CEO compensation and finding other ways to determine it. Most CEO’s compensation is made up of stock and options, which are normally tied to the company’s share price and profitability. Like it or not, a CEO’s success was measured quarter to quarter by the market rather than over the long term as should have been the case. Forbes and Fortune investment magazines were quick to write glowing reviews of new CEO’s under whose watch the share price and profits of a company doubled or tripled in a short period. But this creates a false perception of success. In fact many of the failed CEO’s from AIG, Merrill and Lehman have graced the covers of these top investment magazines. What was never looked at in detail was at what cost were profits and the share price maximized. Now we know. Changing CEO compensation from the myopic link to the short term share price performance to a more long term metric (like contribution to 5 year revenue growth) will result in CEO’s not being forced to take undue risks to maximize short term performance.