What’s $700 Billion Among Friends? – Part 2 of 2

Like the last one, this lengthy (sorry!) post is also written jointly with Sanghamitra Dutt.

Even if the Administration got a $700 billion blank check, no one could guarantee a resolution of today’s crisis. Network effects can still bring down others. For example, so far GM has only wanted a few measly billion dollars of a separate bailout to make investments that it has ignored for decades. If the financial crisis hits GMAC (see the last post), that amount will quickly become a few measly tens of billions. Add a few more incidents and we’ll be in “We don’t remember ever saying $700 billion would be enough” territory.

The question we should discuss in depth is whether a successful resolution of this crisis will automatically forestall another similar one. Not by a long shot! Irrational exuberance is not rare (think of the 17th century “tulip mania” and the tech bubble a decade ago). Indeed, given our networked world, new crises will emerge much more often and with devastating effect unless we strengthen the role of our financial regulators by explicitly making them responsible for managing negative network effects.

Had the House Republicans objected to the bailout because of the lack of such regulatory measures, I would have sympathized with their position. (Strengthening these as a part of the conditions attached to the bailout bill would have been easier than trying to get these adopted once the crisis fades from public view.) Instead, their finding religion after facilitating the dismantling of existing regulations (see, “S.E.C. Concedes Oversight Flaws Fueled Collapse” in The New York Times, 27th September), is nothing but a cynical election ploy.

Simply restoring the status quo will not help; the problem with how our financial networks operate is that individual players have very little visibility across it expanse. So no one sees problems arising early enough and even innocent bystanders get dragged down. To correct this situation, Congress should authorize/enable five critical steps, which are based on my “Design Principles” for networked organizations:

1. Unify the structural relationships among the myriad of regulators. Some time back, recognizing that the lack of cooperation among intelligence agencies was problematical, Congress unified the intelligence agencies under one national office. Though the execution was flawed, the idea was sound. We need a similar step now. If one financial regulator has weaker standards than the others, in a networked world, all financial institutions will still be exposed. I am not recommending centralization of all regulators; I am arguing in favor of legally mandating a coordinating structure that can drive the next four steps.

2. Require regulators to create processes to identify possible emerging crises and empower them to mandate proactive corrective action. In a networked world, seemingly local events traverse great distances rapidly and strike with devastating power. No one pays them attention initially, and even when some get affected, others consider themselves safe. Chairman Bernanke identified (“sensed”) this crisis a year ago; earlier this year, their was much wider awareness of the sub-prime crisis, but most people did not expect AIG to go bankrupt. Today GMAC and others are still at risk.

Assembling coherent corrective actions (“respond”) to head off a growing crisis is even harder. No individual company can do so; collectively many can, but few CEOs would be gutsy enough to expose their own companies if they did not have to. JP Morgan Chase bailed out Bear Sterns only because the Treasury protected it against losses. It is anyone’s guess whether its acquisition of WaMu without similar government protection will help or hurt it.

Moreover, and this is critical, in a networked world, responding to a specific effect of a crisis does little to stop it. That is why the rescue of Bear Stearns, Freddie Mac, Fannie Mae and AIG did not calm the markets. WaMu got liquidated calmly, but now Wachovia looks like the next domino. Stopping the entire crisis cold requires enormous power. That is the real value of the $700 billion. It is large enough to send a strong signal that the government is ready to tackle not AIG or Freddie Mac or Fannie Mae, but the whole enchilada.

To prevent future crises, we need regulators armed with strong sense-and-respond capabilities. Which is why in the last post, I took Secretary Paulson and Chairman Bernanke to task; they sensed (how?), but did not respond (why not?). The how must be analyzed and turned into a robust, replicable process not dependent on the Chairman’s brilliance; that process should be used by all regulators. The why not may have embedded in it serious policy and legislative implications, which must be addressed. For example, if the regulators had no authority to order AIG or Freddie Mac or Fannie Mae from acting in ways that put everyone at risk, they should be given such authority. Note also that the other “safety net” built into the system – the rating agencies like A.M. Best, S&P and Moody’s – also missed the emerging crisis. Were they all asleep at the switch, or were there fundamental underlying issues to which no one paid attention?

3. Require the Treasury and the Fed to immediately begin negotiations with major foreign regulators to create a consistent set of ground rules. The media has reported that European governments are demanding cooperation from the US and the Fed is responding. (E.g., it helped the European Central Bank and others, contributing to a $60 billion liquidity injection to ease the tightness in the LIBOR market.) The real question is: what should the Treasury and the Fed do proactively for the future? America’s financial networks don’t end at its borders. So, it will be difficult to sense the next emerging crisis without the collaboration of foreign regulators. Recent media reports have indicated foreign regulators, even from other G7 nations, grate their teeth at the patronizing behavior of senior US officials. Without a sea change in attitude among US officials, we will continue to be at risk. We must negotiate with them rules and regulations that are consistent across national boundaries. We have to ensure that robust, replicable processes are adopted by everyone. And we have to ensure that knowledge of impending crises are passed on to other regulators quickly. When UBS earns a huge chunk of its revenues and profits in the US, it is no longer a European bank. When Bank of America earns a huge chunk of its revenues and profits outside the US, it is no longer an American bank.

4. Create new analytical tools to better predict effects of market events. National Public Radio reported on the 27th that when he was a professor at Princeton, Chairman Bernanke, co-developed a computer simulation (“Financial Accelerator”) with the type of analytical capabilities mentioned in the last post. If Princeton has this, I sure hope the Fed and the Treasury do too. And yes, let’s share this knowledge with foreign regulators – or adopt their tools if they have better ones. Equally importantly, we need to authorize the regulators to mandate the adoption of such tools by every major financial institution. We have to get past the “one lender – one borrower/one lender – one sector of borrowers” mindset criticized in the last post. I am mindful of the fact that in the post “Beware the Model All Logic,” I cautioned against blind reliance on models; nevertheless, not using essential decision-making tools is equally bad.

5. Use modern information technology to cross link approval structures. As our financial institutions are becoming larger, lending silos make approval decisions about risks in their market niches without talking to each other. Consequently, it is not unheard of for different arms of an institution to offer the same creditor different types of debt with inconsistent legal rights and responsibilities. As such the institutions are losing the ability to see and understand their total exposure across their networks. When crises loom, they can’t tell how they could be affected. (This is a manifestation of a problem that affects all networks: distribution of work across time and space compromises visibility.) This confusion is mirrored externally by the existence of a myriad of (albeit defanged) regulatory bodies with overlapping jurisdictions.

To assure better visibility and to facilitate analysis of complex decisions, we must use modern technologies more effectively. For example, technology can flag problems that could arise from inconsistencies far more quickly and more thoroughly than a human can. Being forewarned, decision-makers can now act – or be held accountable for not doing so. Regulators should be empowered to demand the implementation of modern IT both within their own bailiwicks and also to transfer critical information on a timely basis to regulators. The regulators should be able to use the information to question executives about actions that could threaten the network – and force them to cease-and-desist.

Implementing this guideline will raise all sorts of difficult policy questions about protecting proprietary information, the governance responsibilities of Boards and the like. But that is the fundamental conundrum we are not wrestling with today: modern technologies have created the networked world. We have embraced the networks with both arms because of the benefits they offer, but we have not re-thought how our laws, strategies, processes, values, analytical tools and yes, even technologies, must be updated to function within them.

There’s no question that many executives involved in the present crisis were rapacious and deserve to be penalized. There is also no question that many policy setters are ideologues who would like to do nothing better than demonize each other rather than solve problems. But unless we actually reform the underlying mindset, processes, tools and technology, we – and other major economies –will be doomed to shelling out trillions of dollars of pocket change ever so often.

Category: Business Environment, Business Tools, Company Performance Comment »

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