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Financial Reporting and Regulation in a World of Financial Engineering: Accounting and the Global Financial Crisis. Shyam Sunder, Yale University Journal of Accounting and Public Policy Conference on Accounting and the World Economic Crisis IE University, June 14, 2013 Segovia, Spain.

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Financial reporting and regulation in a world of financial engineering accounting and the global financial crisis

Financial Reporting and Regulation in a World of Financial Engineering: Accounting and the Global Financial Crisis

Shyam Sunder, Yale University

Journal of Accounting and Public Policy Conference on

Accounting and the World Economic Crisis

IE University, June 14, 2013

Segovia, Spain

Sunder: Financial Regulation & Engineering

An overview
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?

  • What can be done?

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Overview contd
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 Basel, Norwalk, or London, has or can overcome this disadvantage.

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Overview contd1
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.

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Some maintained premises of financial reporting and regulation

Some Maintained Premises of Financial Reporting and Regulation

Sunder: Financial Regulation & Engineering

1 global standards
1. Global Standards Regulation

  • 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?)

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2 written standards
2. Written Standards Regulation

  • 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

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3 clear standards
3. Clear Standards Regulation

  • 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

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4 the static ideal
4. The Static Ideal Regulation

  • 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

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5 people or structure
5. People or Structure Regulation

  • 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

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6 crafting standards through deliberation
6. Crafting Standards Regulationthrough 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)

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7 specialization in setting standards
7. Specialization in Setting Standards Regulation

  • 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)

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8 distinguishing good from bad
8. Distinguishing Good from Bad? Regulation

  • 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)

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9 regulatory monopolies
9. Regulatory Monopolies Regulation

  • 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

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11 competition and race to the bottom
11. RegulationCompetition 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.)

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12 force and effectiveness
12. Force and Effectiveness Regulation

  • 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

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13 statutory approach dominates common law
13. RegulationStatutory 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)

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14 written standards are better than social norms
14. RegulationWritten 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.)

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15 who defends the middle ground
15. Who defends the middle ground? Regulation

  • 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

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16 financial regulation and reporting is improving
16. RegulationFinancial 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?

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17 permitting fewer alternatives yield better outcomes
17. Permitting Fewer Alternatives Yield Better Outcomes Regulation

  • 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

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18 monitor s bargaining power
18. Monitor’s Bargaining Power Regulation

  • 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

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19 individual responsibility
19. Individual responsibility Regulation

  • 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; check-box mentality

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20 education
20. Education Regulation

  • 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

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Emphasis on written regulations
Emphasis on Written Regulations Regulation

  • Reasonable arguments for written regulations

  • But also, reasonable limitations and criticisms of excessive dependence on written regulations

  • Examine some consequences of increasing dependence

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Credit rating agency reforms
Credit Rating Agency Reforms Regulation

  • 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

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Taxation of multinational firms
Taxation of Multinational Firms Regulation

  • 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

Yen libor manipulation
Yen Libor Manipulation Regulation

  • 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

No free lunch in bank capital regulation
No Free Lunch in Bank Capital Regulation 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

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Basel ii bank capital regulation
Basel II Bank Capital Regulation 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

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How does basel iii address this problem
How Does Basel III Address this Problem? Regulation

  • 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

Basel i ii iii and counting
Basel I, II, III, … and Counting Regulation

  • “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

Consequences of deposit insurance
Consequences of Deposit Insurance Regulation

  • 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

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Financial engineering and financial regulation
Financial Engineering and Financial Regulation 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

Regulation as a social phenomenon
Regulation as a Social Phenomenon Regulation

  • 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

Why regulation of financial services
Why Regulation of Financial Services? Regulation

  • 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

Regulatory performance
Regulatory Performance Regulation

  • 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

Objectives of financial engineering
Objectives of Financial Engineering Regulation

  • 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

Objectives in financial engineering
Objectives in Financial Engineering Regulation

  • “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

Securitization Regulation

• 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 finance

International Finance Corporation

Sunder: Financial Regulation & Engineering

What is off balance s heet financing
What is Off-Balance RegulationSheet 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

How and why do loan originators optimize balance sheet management
How and Why Do Loan Originators RegulationOptimize 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

Does financial engineering create value
Does Financial Engineering Create Value Regulation

• 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

Financial regulatory standards as constraints on financial optimization
Financial RegulationRegulatory 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

Redesigning contracts
Redesigning Contracts Regulation

  • 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

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Redesigning transactions
Redesigning Transactions Regulation

  • 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

Redesigning the organization
Redesigning the Organization Regulation

  • 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

Asymmetric game
Asymmetric Game Regulation

  • 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

The net effect
The Net Effect Regulation

  • 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

Why difficulty writing regulatory standards for derivatives
Why RegulationDifficulty 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

Standards and language
Standards and Language Regulation

  • Standards of financial reporting and regulation must necessarily be specified in language

  • Language, in order to be useful, must necessarily have certain imprecision around the meaning of words

  • Can we specify precisely the meaning of a house, or shirt, or table? Instead reliance on usage—a matter of social norms

  • What happens if we try to do so?

  • Regulators have tried to counter financial engineering by resorting to the fiction that more precise definitions of words, e.g., assets, liabilities, income, regulatory capital, etc. will solve the problem

  • But they have not, and they cannot; bound to fail

Sunder: Financial Regulation & Engineering

A newspaper example of too big to fail
A Newspaper Example (of Too-Big-to-Fail) Regulation

  • Among a number of sensible amendments under development, Senator Sherrod Brown (D., OH) proposes the following language:

  • "LIMIT ON LIABILITIES FOR BANK HOLDING COMPANIES AND FINANCIAL COMPANIES.--No bank holding company may possess non-deposit liabilities exceeding 3 percent of the annual gross domestic product of the United States."

  • A few paragraphs later, the language considers derivatives:

  • "OFF-BALANCE-SHEET LIABILITIES.--The computation of the limit established under subsection (a) shall take into account off-balance-sheet liabilities."

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Regulatory language as a constraint
Regulatory RegulationLanguage as a Constraint

  • A strong provision for requiring prompt corrective action if any bank exceeds this hard size cap.

  • How many financial engineers and accountants think that this is a hard cap on size, or if it is a cap at all?

  • What will happen if this language became the law to cap the size of financial institutions? (independent of whether you think their size should be capped)

Sunder: Financial Regulation & Engineering

Yet the debate goes on
Yet the Debate Goes On Regulation

  • Naturally, the Federal Reserve is pushing back.

  • The Fed's argument is that any kind of size limitation would be too blunt an instrument - successful regulation requires nuance and subtlety.

  • Perhaps, but there's a big problem with relying on subtle regulators. Over the past thirty years, almost all our regulators and supervisors have become either sleepy or captured - in a cognitive sense - by the very people they are supposed to be watching over. (Chapters 3 and 4 in 13 Bankers document this in detail)

Sunder: Financial Regulation & Engineering

These are good points but largely irrelevant
These are Good Points, but Largely Irrelevant Regulation

  • … Or just think about this. The New York Fed is run by a senior executive of Goldman Sachs. At the same time, the former head of the New York Fed holds a top position at Goldman - where he is responsible for interacting with regulators around the world. And the practices, if not the explicit rules, of the New York Fed apparently permit its board members to buy stock in companies that the Fed oversees. Please explain exactly how this web of arrangements will help keep regulation strong and effective moving forward.

  • The point is: Can regulatory and accounting rules written in English words serve as effective constraints on financial engineering?

  • My answer is no. I hope this is not true.

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Social norms of accounting and finance
Social Norms of Accounting and Finance Regulation

  • I personally doubt that a non-cooperative game between financial engineers and regulators has led us to a socially efficient outcome

  • Regulators have, over the past eight decades, increasingly come to rely on written rules as opposed to their judgment and social norms of their profession

  • Financial engineers, on the other hand consider it their own professional duty to design whatever instruments/transactions/organizations will best serve the immediate interests of their clients under the prevailing written standards of financial reporting

  • Social norms play a diminishing, if any, role on either side

  • Is it possible that some part of the blame for the systemic failures of the recent years may be linked to this diminishing role?

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Ethics and moral code in business programs
Ethics and Moral Code in Business Programs Regulation

  • Shiller: “Many schools now offer a course in business ethics, and some even try to integrate business ethics into their other courses. But nowhere is ethics seen as the centerpiece or even integral part of the curriculum. And even when business students do take an ethics course, the theoretical framework of the core courses tends to be so devoid of any moral content that the discussion of ethics must seem like some side order of overcooked vegetable”.

  • If the role of ethics in curriculum is minimal, what is the role of ethics (i.e., social consequences of our work) in choosing the substantive topics of our research

  • Identifying mispricing of securities, for example, may help move prices to more efficient levels

  • What about identifying a way of redesigning a transaction so a financial obligation will not show up on the balance sheet under the prevailing regulatory standards?

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In summary
In Summary Regulation

  • With the development of mathematical finance, financial engineers rapidly redesign transactions, instruments, and business entities to render prudential and reporting regulation in the financial services ineffective.

  • This new reality has been a key element of the celebrated regulatory and reporting crises of the past dozen years.

  • Band-aid solutions for this new fundamental reality (such as Basel III and IFRS fair value accounting) have little prospect of success

  • What, if any thing, should we, and can we do about this?

  • Are there some alternatives to bringing in a sense of social responsibility for the consequences of our research agendas? If so, let us explore them.

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Good banking is boring
Good Banking is Boring Regulation

  • Our lives depend on efficient functioning of many systems (e.g., electrical wiring, plumbing, foundations of our buildings, telephones, and computer networks)

  • All such essential and critical systems are made efficient and routine to the point of being boring, low paying jobs, following pre-specified procedures and codes.

  • Innovations are slow, but made only after much experience and regulatory deliberation.

  • Excitement in such essential fields portends disaster (e.g., electrical wiring of Boeing 787 Dreamliner)

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Creativity in finance
Creativity in Finance Regulation

  • These consequences of financial engineering suggest that the social consequences of creativity in finance can be as socially detrimental as creativity in accounting

  • Objects of finance consist of (are defined) entirely by the relevant covenants and the accounting system

  • To the extent financial institutions have significant social externalities, and receive special support in form access to borrowing from the central banks

  • Their transactions have to confined to those conforming to a pre-approved template.

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A lesson from history
A Lesson from History Regulation

  • Financial services became exciting and high-paying in the 1920s, and dropped to a low level after the great crash of 1929.

  • After half-a-century of excitement and high paying jobs and finance, we have seen another global crisis.

  • We need to assess the contribution of the new finance to GDP and social welfare, and assess if it is better to return it to a boring trade which is confined to a small set of pre-approved transactions.

  • Remuneration of people working in such an industry will return to low levels, but the rest of society may be safer and prosperous.

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New problems new solutions
New Problems, New Solutions Regulation

  • We may often assume that financial regulation and governance problems originated in the 20th century

    • History tells us otherwise

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Financial reporting and regulation in a world of financial engineering accounting and the global financial crisis

Westminster Hall Regulation

Trial of Warren Hastings

London: Published for the Proprietor by J. Mead, 10, Gough Square, Fleet Street

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Thank you

Thank You. Regulation\faculty\sunder

Sunder: Financial Regulation & Engineering

References Regulation

  • Hans J. Blommestein, “The Financial Crisis as a symbol of failure of academic finance (a methodological digression), The Journal of Financial Transformation, Fall 2009.

  • G. Gorton and N. Souleles, “Special Purpose Vehicles and Securitization,” FRB Philadelphia Working Paper, 2005.

  • Henry, David, Heather Timmons, Steve Rosenbush, and Michael Arndt (2002), “Who else is hiding debt?,” Business Week (January 28), 36-37.

  • J. Huber, M. Shubik, and S. Sunder, “Default penalty as disciplinary and selection mechanism in presence of multiple equilibria,” Cowles Foundation Working Paper 1730, October 2009.

  • K. Klee and B. Butler, “Asset-Backed Securitization, Special Purpose Vehicles

  • and Other Securitization Issues,” Uniform Commercial Code Law Journal 35 (2002), 23-67.

  • J. Mason, E. Higgins and A. Mordel, “Asset Sales, Recourse, and Investor Reactions to Initial Securitizations: Evidence Why Off-balance Sheet Accounting Treatment Does not Remove On-balance Sheet Financial Risk” LSU Working Paper, 2009.

  • Robert J. Shiller, “How Wall Street learns to look the other way,” The New York Times, Feb. 8, 2005.

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  • Shyam Sunder, “Determinants of Economic Interaction: Behavior or Structure.”Journal of Economic Interaction and Coordination 1, no. 1 (May 2006): 21-32.

  • Shyam Sunder, “’True and Fair’ as the Moral Compass of Financial Reporting,” in Cynthia Jeffrey, ed., Research in Professional Responsibility and Ethics in Accounting (Forthcoming 2009).

Sunder: Financial Regulation & Engineering