Financial Regulation in a World of Financial Engineering?

1. Financial Regulation in a World of Financial Engineering? Shyam Sunder, Yale University Cheng Tsang Man Chair Visiting Professor School of Accountancy Singapore Management University Singapore, January 18, 2013 Sunder: Financial Regulation & Engineering

2. An Overview • Great efforts made to write effective regulatory standards—accounting as well as prudential—for financial services industry. • Events of the recent decade show that these efforts have largely failed to achieve their stated objectives, both globally as well as in major economies of the world. • Why? Sunder: Financial Regulation & Engineering

3. Overview (Contd.) • A root cause of these regulatory weaknesses and failures lies in inability of regulation to deal with the challenge presented by financial engineering. • Regulators, constrained by governments, business and profession, take years to write the rules and standards. • Their labor of love—carefully drafted regulations—is soon rendered ineffective when financial engineers and lawyers design of new instruments, transactions and organizations to bypass the regulations. • No amount of wisdom and hard work by regulators, whether located in Basle, Norwalk, or London, has or can overcome this disadvantage. Sunder: Financial Regulation & Engineering

4. Overview (Contd.) • Modern mathematical finance and financial engineering can bypass just about all written regulations without difficulty. • Written regulations, as an instrument of regulating financial services industry, do not work. • What are the alternatives, and their pros and cons? • No easy solutions. Sunder: Financial Regulation & Engineering

5. Some Maintained Premises of Regulation Sunder: Financial Regulation & Engineering

6. 1. General Standards • General standards of financial reporting and regulation applied across time, economies, industries and corporate size and organizational forms best serve the society (e.g., Basel, IFRS, FAS). • Standardization does save costs and effort, (electrical plugs, clothing, cars, street grids, commercial codes) • Becomes counterproductive beyond certain limits when environments to which they are applied are diverse • How do we know the limit of standardization? • Rhetoric of universal accounting standards and universal language (Esperanto?) Sunder: Financial Regulation & Engineering

7. 2. Written Standards • It is fair and efficient to write down the regulatory standards for everyone to know and comply with (e.g., the Code of Hamurabi). • Written standards promote our sense of fair play in a democratic society to avoid arbitrariness and partiality • But all contingencies cannot be anticipated and written down. • Written standards constrain discretion in enforcement • They also serve as “road maps for evasion” and gaming to take advantage of the rules Sunder: Financial Regulation & Engineering

8. 3. Clear Standards • Clear standards make it easier to know what is permitted and what is not permitted. • No standard can be made “perfectly clear” • No matter how much detail we put in the rules, there will always be demand for further clarification and “guidance”; rule books grow • Do additional details in standards reduce or increase the loopholes? • 3 percent rule for Special Purpose Entities => Enron Sunder: Financial Regulation & Engineering

9. 4. The Static Ideal • There exists an ideal set of written reporting and regulatory standards that, once discovered and implemented, will induce corporations and banks to function efficiently in conformity with the regulations • Dynamics of the game between managers and standard setters makes any such static ideal all but impossible • Regulatees see standards as constraints and modify their decisions to seek their own goals Sunder: Financial Regulation & Engineering

10. 5. People or Structure • If we select knowledgeable, experienced, self-less, public-spirited, and wise individuals to constitute bodies that devise regulatory standards through deliberation and due process, we can improve the functioning of the economy. • Yes, but individuals stand where they sit. • We place much emphasis on the quality of individuals; • Insufficient attention given to the structure of game that regulators and regulatees play Sunder: Financial Regulation & Engineering

11. 6. Crafting Standards through Deliberation • It is possible to construct or discover better written regulatory standards through deliberation in properly organized corporate entities (Basel Committee, Federal Reserve, IASB, etc.). • Assumes that such bodies can know the consequences of their actions (Cartesian perspective on the problem) • Little evidence in history to support this proposition • Written standards by authoritative bodies have repeatedly failed to yield their stated outcomes (e.g., global financial crisis) Sunder: Financial Regulation & Engineering

12. 7. Specialization in Setting Standards • Specialist standard setting bodies, standing ready to address new problems, inquiries and requests for clarifications help improve regulation • Their existence encourages a new “clarification” game targeted at them • They must keep a full agenda (performance) • Revenue and budget pressures • Over time, their written output must accumulate to a thick rule book (e.g., Basel I, II, III; IFRS) Sunder: Financial Regulation & Engineering

13. 8. Distinguishing Good from Bad? • Standard setters can tell which written standards are better, and why; and what would happen if a rule were left unwritten • Little evidence that they know, or can know • For example, cost-of-capital is the result of complex interactions among many factors • These influences cannot be sorted out by ex ante analysis • Ex post analysis of data to assess the impact of regulatory standards is confounded with other factors which may have changed simultaneously (collinearity) Sunder: Financial Regulation & Engineering

14. 9. Regulatory Monopolies • Granting monopoly power in a given jurisdiction to standards written by a given body can help improve regulation • Informational disadvantage of a monopoly • No opportunity for experimentation • No opportunity to learn from the experience of alternatives; arrogance • No pressure to do better, or to correct errors • Pros and cons of regulatory competition Sunder: Financial Regulation & Engineering

15. 11. Competition and Race to the Bottom • A regime that encourages reporting entities to choose among the standards written by competing organizations (and paying them a royalty for the privilege) induces a “race to the bottom” to devise less demanding standards • Many counter examples (Stock exchanges, bond rating services, appliance standards, college accreditation, bank regulation, corporate charters across 50 states in U.S., etc.) Sunder: Financial Regulation & Engineering

16. 12. Force and Effectiveness • Increase in the power of enforcement behind authoritative standards improves compliance and quality of regulation and reporting • Increased enforcement also increases resources devoted to evasion • Draconian punishments do not necessarily induce better behavior • Crime, alcohol and drug abuse (recent report on failure of the War on Drugs) • Cutting hands of thieves may not be an efficient way to reduce theft Sunder: Financial Regulation & Engineering

17. 13. Statutory Approach Dominates Common Law • The quasi-statutory approach to setting regulatory standards (writing everything down) dominates a common law approach to financial reporting (leave significant parts unwritten, and subject to professional judgment) • Evidence? • Constitution (U.K., U.S., Singapore) Sunder: Financial Regulation & Engineering

18. 14. Written Standards are Better than Social Norms • Written standards backed by power of enforcement work better than unwritten social norms backed only by internal and external informal sanctions • Social norms govern great parts of our lives including many aspects of law • Insider trading example • Guilty beyond reasonable doubt • Private commercial codes (cotton, diamond trades in U.S.) Sunder: Financial Regulation & Engineering

19. 15. Who defends the middle ground? • The ideal regulatory regime consists of either all written standards or all social norms • Easier to make the extreme cases for standards or norms alone • Difficulty of defending the middle ground where both written and unwritten standards may co-exist, as they do in many other aspects of our lives Sunder: Financial Regulation & Engineering

20. 16. Financial Regulation and Reporting is Improving • 100 years of U.S. federal bank regulation and 80 years of federal regulation of securities and financial reporting has helped improve the quality of regulation. • Evidence? • Is a thicker rulebook indication of better regulation? • Perfect correlation between financial reports and stock returns? • How do we judge if regulations are getting better? Sunder: Financial Regulation & Engineering

21. 17. Permitting Fewer Alternatives Yield Better Outcomes • Fewer the alternatives permitted to the regulatees, the better the quality of regulation. • Fewer alternatives also tie the hands of the management of well-run companies who may wish to signal their confidence, competence and prospects by choosing reporting practices others find difficult to emulate. • Permitting fewer choices reduce information through signaling Sunder: Financial Regulation & Engineering

22. 18. Monitor’s Bargaining Power • Well-specified standards enhance the bargaining power of the monitor/auditor vis-à-vis the regulated organization • Standards also encourage regulatee to demand: show me the rule • Reduced reliance on judgment • More detailed the standards, greater the part of monitor’s work that can be replaced by a computer, and lower the value of the service Sunder: Financial Regulation & Engineering

23. 19. Individual responsibility • Written regulatory standards strengthen the individual responsibility of managers, regulators, auditors, and investment bankers for fair representation • On the contrary, they may undermine individual responsibility for fair representation and the big picture by shifting attention to meeting the letter, not spirit, of the specific provisions and their wording Sunder: Financial Regulation & Engineering

24. 20. Education • Written standards help improve education and attract talent to the profession • Written standards degrade the class room from reasoning and intellectual debate to rote memorization • They make it less attractive to young talent Sunder: Financial Regulation & Engineering

25. Emphasis on Written Regulations • Reasonable arguments for written regulations • But also, reasonable limitations and criticisms of excessive dependence on written regulations • Examine some consequences of excessive dependence Sunder: Financial Regulation & Engineering

26. Credit Rating Agency Reforms • Efforts to reform credit agencies: require shift from issuer to investor pays model. • “Rocked by public and political distaste for the role they played in the global crisis, the big three credit rating agencies were expected to make profound changes—but efforts to reform have come unstuck.” Stephen Foley in “Outlook Unchanged,” The Financial Times, p. 5, January 15, 2013 Sunder: Financial Regulation & Engineering

27. Taxation of Multinational Firms • Tax rates of multinational have dropped in the recent decades far more than the drop in national tax rates. • “Governments want to close loopholes that help multinationals avoid tax but will have to balance any crackdown against their need to attract big foreign investors.” VenessaHoulder, “Unsafe Offshore,” The Financial Times, p. 5, January 14, 2013. Sunder: Financial Regulation & Engineering

28. Yen Libor Manipulation • If you keep the six-month Japanese yen Libor unchanged for the day, “I’ll pay you $50,000, $100,000 …whatever you want …I’m a man of my word.” Hayes of UBS AG. • “I dun mind helping on your fixings, but I am not setting libor 7 points away from the truth (69 points). I’ll get UBS banned if I do that.” Darin • He submitted 67. • William D. Cohan, UBS Libor Manipulation Deserves the Death Penalty,” in Bloomberg News, December 23, 2012. Sunder: Financial Regulation & Engineering

29. No Free Lunch in Bank Capital Regulation • Basel II raised the bank capital requirement • Bank responded by getting their loans off their books through securitization so they will have to hold less capital (and earn a higher return on it) • “Capital regulation based on risk-weighted assets encourages innovation designed to circumvent regulatory requirements and shifts banks' focus away from their core economic functions.” "Systemically Important Banks and Capital Regulation Challenges". OECD Publishing. December 2011. • Banks misclassified the risk of their assets to avoid holding more capital Sunder: Financial Regulation & Engineering

30. Basel II Bank Capital Regulation • 2007: Capital was 11 percent of risk-weighted assets for 10 largest US banks • But if you excluded goodwill, intangibles and deferred tax assets (which tend to become worthless under financial stress), their capital was only 2.8 percent Sunder: Financial Regulation & Engineering

31. How Does Basel III Address this Problem? • More arcane and complex rules for calculating bank capital (opening more loopholes for financial engineering your way around the capital standards • Set the capital/asset requirement to 3 percent (about the same as the actual 2007 level) Sunder: Financial Regulation & Engineering

32. Basel I, II, III, … and Counting • “Each new Basel (bank capital) standard attempts to correct the errors and unintended consequences of earlier versions. But instead of resulting in better outcomes, each do-over has been more complicated and less effective than the last. Most disturbingly, each fails to provide enough real capital to absorb unexpected shocks to the economy.” Thomas M. Hoenig (Vice-Chairman FDIC), “Get Basel III Right and Avoid Basel IV,” The Financial Times, December 12, 2012. Sunder: Financial Regulation & Engineering

33. Consequences of Deposit Insurance • Shifted the burden of ensuring bank capital adequacy to regulators from depositors • Regulators must have written rules to avoid appearing arbitrary or biased • Written rules also serve as “roadmaps for evasion” • Post-FDIC, depositor disinterest in monitoring cut bank capital from an average of 10 to about 3 percent (about 2 percent for some large EU banks) • Is it better to shift some (e.g., 50%) or all of the responsibility for monitoring banks back to depositors Sunder: Financial Regulation & Engineering

34. Financial Engineering and Financial Regulation • These are just a few examples of the conflict between financial regulation and financial engineering. • How long can the regulatory walls hold? • Basel I proposed in 1988, and lasted for 16 years • Basel II proposed in 2004 and lasted less than half-a-dozen years (until the financial crisis 2007-10) • Basel III proposed in 2010, and has already been hollowed under industry pressure by the end of 2012, even before its implementation began Sunder: Financial Regulation & Engineering

35. Regulation as a Social Phenomenon • Social phenomena exist macroeconomic, organizational, and individual levels • At each level, agents (individuals, organizations, and government): • Interact with one another, • Learn over time, • Resulting in feedback and endogeneity (X affects Y, as well as Y affects X) • I would like to discuss one aspect of such interactions between financial regulation and financial engineering, and its consequences Sunder: Financial Regulation & Engineering

36. Why Regulation of Financial Services? • Financial regulation is a form of regulation or supervision, which subjects financial institutions to certain requirements, restrictions and guidelines, aiming to maintain the integrity of the financial system: • to sustain systemic stability, • to maintain the safety and soundness of financial institutions, and • to protect the consumer. Sunder: Financial Regulation & Engineering

37. Regulatory Performance • Lindgren et al., 1996: In recent years, bank failures around the world have been common, large and expensive. • Llewellyn (1998a) concludes that three common elements emerge in banking crises: bad incentive structures, weak management and control systems within banks, and poor regulation, monitoring and supervision. • Why such poor performance? • Because of interplay with financial engineering Sunder: Financial Regulation & Engineering

38. Objectives of Financial Engineering • Objective in corporate financial engineering: to design transactions to optimize from the point of view of the organization, e.g., increase assessed creditworthiness and lower risk based on facts and appearances of its financial reports Sunder: Financial Regulation & Engineering

39. Objectives in Financial Engineering • “The Financial Engineering Concentration encompasses the design, analysis, and construction of financial contracts to meet the needs of enterprises.” (Cornell’s ORIE M.S. concentration in financial engineering) • What are these needs? • In at least some cases, these needs consist of finding ways of • Reducing indebtedness on the balance sheet, or • Reducing expense on income statement, or • Increasing revenue on income statement, or • Increasing deductions on tax returns Sunder: Financial Regulation & Engineering

40. Securitization • A form of off-balance sheet financing which involves the pooling of financial assets • Risk transfer mechanism that allows loan originators to optimize balance sheet management • Allows highly rated securities to be created from less credit worthy assets • Can be in local or foreign currency, depending on client needs • A rapidly growing asset class with proven benefit for emerging market borrowers • For summaries of prior deals, please visit www.ifc.org/structured finance International Finance Corporation Sunder: Financial Regulation & Engineering

41. What is Off-Balance Sheet Financing • Borrow money in such a way so under the regulatory standards, it does not show up as a liability on the balance sheet. • That is, find a way around written standards so an obligation to pay does not show up as a liability in the financial reports. Sunder: Financial Regulation & Engineering

42. How and Why Do Loan Originators Optimize Balance Sheet Management • Loan originators (e.g., banks) are exposed to risk when they give loans • Inclusion of the loan in assets of the firm reflects this exposure to risk, and limits bank’s ability to make further loans under prudential regulation • By devising securitization so the risk exposure is reduced just below the written regulatory threshold, bank can exclude the asset from the balance sheet • This exclusion allows the bank to more more loans than prudential regulation would otherwise permit • This is the risk transfer mechanism that allows loan originators to optimize balance sheet management Sunder: Financial Regulation & Engineering

43. Does Financial Engineering Create Value • Allows highly rated securities to be created from less credit worthy assets •Payoffs of any asset can be partitioned into parts, some of which are more risky (and yield high return) and others are less risky and yield lower return • Can the sum of the values of these parts systematically exceed the value of the unpartitioned asset in absence of mis-information, mis-estimation, or extraneous cash consequences such as taxes? Sunder: Financial Regulation & Engineering

44. Financial Regulatory Standards as Constraints on Financial Optimization • In such optimization, standards of financial regulation are treated as constraints • Most optimization problems have hard constraints—their violation brings well-specified penalties (dual prices) • With optimization confined by the production possibilities set and other such physical limitations, external constraints make a real difference to the final actions and outcomes • What kind of constraints do standards offer? • I am going to argue that these standards offer softer constraints because the forms of contracts, transactions, as well as organizational forms that businessmen can devise and use are beyond the scope of accounting standards Sunder: Financial Regulation & Engineering

45. Redesigning Contracts • A manufacturer needs to buy a machine for the factory • Borrowing is an option, but the manufacturer does not want more debt on its balance sheet • The leasing subsidiary of a bank buys the machine and gives it to the manufacturer on a long term lease—machine is in the factory but no debt on balance sheet! • FASB writes Standard 13: leases >90%V and >75%T must be treated as capital leases (debt is back on BS) • The bank revises the lease to levels below the thresholds specified in the standard (debt is off the BS) • FASB goes back to work, and so on … until the leases rulebook grows to over a 1,000 pages with no end to this growth in sight Sunder: Financial Regulation & Engineering

46. Redesigning Transactions • Depending on the current standards of financial reporting, transactions can be redesigned to achieve the desired consequences for revenues, expenses and taxes Sunder: Financial Regulation & Engineering

47. Redesigning the Organization • When design of contracts and transactions is not sufficient, organizations themselves can be redesigned, or new ones created in order to have the desired consequences for balance sheets, income statements and tax returns • Special purpose entities (SPEs and SPVs) are examples of organizations created for this purpose (see Klee and Butler 2002 and Gorton and Souleles 2005) • “Hundreds of respected U.S. companies are ferreting away trillions of dollars in debt in off-balance sheet subsidiaries, partnerships, and assorted obligations” (Henry et al. 2002) Sunder: Financial Regulation & Engineering

48. Asymmetric Game • Note that financial reporting standards neither have, nor can have, any say in any of these “business” decisions of the management • The role of the accountant and auditor is limited to preparing financial reports given all these decisions • While these decisions clearly consider what the accounting standards are, accountants have little freedom to take into account how and why these decisions were taken in the first place • There is great asymmetry between the freedom available to the business decision makers and constraints on the accountant who must abide by relatively rigid written standards in deciding how to report the performance and financial status of an organization Sunder: Financial Regulation & Engineering

49. The Net Effect • The decision to write an accounting standard is a matter of social policy that calls for a deliberative due process; it typically takes years to determine which rules might best serve investors and others. Inevitably, these standards are written on the assumption that the current forms of contracts, transactions, and organizations will continue to be used in the future when these standards are applied • The decision to change contracts, transactions and organization is an individual decision that may be taken within days if not hours. Further, the scope of these decisions is virtually unbounded (except by the imagination of the businessmen). Soon after the standards are issued, the environment to which they are applied changes relative to the what the standards were written for • The net effect: Financial reporting standards serve as relatively weak constraints (if at all) on what businesses can do and on what they report (relative to their underlying economics) Sunder: Financial Regulation & Engineering

50. Why Difficulty Writing Regulatory Standards for Derivatives? • Some derivatives are designed to get around the intent (provision of information) of the extant financial reporting standards • How does one write standards for these instruments? • Is it possible to have an equilibrium between design of such instruments and standards for reporting them? • The problem seems to have gone largely unnoticed in the flurry of proposals on financial reforms now on the table • The question is: Are the optimization in financial engineering (relative to prevailing reporting standards), and search for standards that provide useful information to investors mutually consistent goals? Sunder: Financial Regulation & Engineering