Risky Business: The Credit Crisis and Failure (Part III)

Olufunmilayo B. Arewa[*]

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I. Consumers, Industry, and Regulatory Costs

Collection and effective analysis of financial market data may help prevent future crises.  The high human costs of market crises, which may significantly affect those least well positioned to bear such costs,[1] make prevention of future crises a high priority.  This is particularly true in light of the pervasive financial market networks that characterize contemporary financial markets.  Further, through their influence on financial variables such as interest rates and currency prices, financial market networks reach deep into the homes and pocketbooks of a significant portion of the world’s population.[2]  The fallout from the subprime mortgage market collapse thus illustrates fundamental ways in which financial market participants and the broader global community are linked.

Risky Business: The Credit Crisis and Failure (Part II)

Olufunmilayo B. Arewa[*]

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I. Regulatory Failures and Regulatory Reform

The credit crisis underscores the need for reform of regulatory and industry approaches to risk.  Reframing risk should entail greater limitations on leverage and more comprehensive internal company risk management, with both external regulatory monitoring and more robust internal efforts.  As a number of post-credit crisis compensation proposals have recommended, companies should also be encouraged to follow best practices with respect to compensation and bonuses based on performance.[1]  Best practices should involve greater consideration of the ways in which compensation rewards take account of risks, particularly for traders whose activities entail significant risk exposure.[2]  Such best practices in compensation might include, for example, creating a clawback or tail for compensation that matches the time horizon of receipt of compensation to the time horizon of trading activities for which an employee is compensated.  Regulated companies in the financial services industry should also be required to disclose their internal risk management strategies in detail, as well as the alignment between compensation and risk, in order to comply with mandatory disclosures in risk disclosure discussions.  All regulated and unregulated firms should also be required to immediately report all material incidents that reflect a failure of risk controls or risk management to a market stability regulator.  External regulation can be used to promote development of internal risk management in the financial industry.  The credit crisis, however, raises serious questions about the effectiveness of existing financial market regulatory approaches.

Risky Business: The Credit Crisis and Failure (Part I)

Olufunmilayo B. Arewa[*]

[download pdf]

Introduction

The credit crisis represents a watershed event for global financial markets and has been linked to significant declines in real economy performance on a level of magnitude not experienced since World War II.[1]  Recognition of the crisis in 2008 has been followed in 2009 and 2010 by a plethora of competing proposals in response to the credit crisis.[2]  The result has been a cacophony of visions, voices, and approaches.  The sheer noise that has ensued threatens to drown out the fundamental core questions that should be asked about the credit crisis.  Among the most important are questions about the relationships between risk, regulation, and failure.

The credit crisis can be viewed as a type of financial market network failure.[3]  The credit crisis underscores the complex and linked nature of contemporary financial markets, as well as the inherent difficulties regulators and industry participants face in managing complex and interconnected risks.  The credit crisis also demonstrates that neither industry participants nor regulators fully apprehended underlying financial market risks.  In recent years, financial products and financial markets have become increasingly complex and global.[4]  Although public commentary and policy discussions in the credit crisis aftermath focused on the implications of financial services firms that are “too big to fail,”[5] existing commentary devotes less attention to the network-like characteristics of financial markets and the implications of complex networks for financial markets.[6]  The impact of financial market networks is heightened by the pervasive cultures of trading and risk-taking that now characterize many market segments.[7]  The risk-taking associated with financial market trading activities is perhaps best illustrated by cases of individual traders who took on risky trading positions that significantly compromised or, in the case of Baring Brothers, destroyed the firms on whose account they trade.[8]