New Optimal Financial and Banking Regulation

March 31, 2008

Dr. Ben Bernanke, Chairman, Federal Reserve Board

20th & Constitution Ave NW
Washington, DC 20551

Sub:     Regulatory Reform

Dear Dr. Bernanke,

The root cause of the current financial market meltdown is the power of predatory lenders to observe the security holdings of their borrowers and then to short sell those securities to issue margin calls and to liquidate the borrowers’ assets for a windfall. This has first happened to leveraged households and then spread to nonbanks like investment banks and hedge funds.  Specific ideas are proposed in the memorandum.    

A. Optimality of New Regulation

It is optimal for a lender of last resort (the Federal Reserve) to monitor both banks and nonbanks that undertake risks, which can cause instability in the financial markets, necessitating injection of Fed funds to prevent systemic risk from engulfing the economy.

Investment banks are de facto hedge funds.  Since investment banks are treated as nonbanks, all hedge funds not registered as investment banks should also be treated as nonbanks.  Fed monitoring should, therefore, include all entities that currently borrow from federally insured commercial banks or may need Fed funds during a crisis.  Only those nonbanks (including hedge funds) that have no debt in their balance sheets should not be monitored.  This is a sound principle of finance that can be supported by any reasonable economic theory.  

As a benevolent lender of last resort, Fed should monitor all predatory lenders and nonbank borrowers, in the best interest of society.

B.  A two-step Monitoring System

The first step in Fed’s monitoring is straight forward: require all nonbanks including hedge funds to report their debt positions including the sources. 

The second step in Fed’s monitoring is more complicated: it is to set the trigger for allowable leverage of nonbanks.  To set a trigger, the capital position of a nonbank should be valued and a minimum threshold should be set. 

How should the Fed value nonbanks’ assets including derivatives?

This question was the focus of many econometric models used to determine the charge-off that were presented in a 1990 meeting at the Federal Reserve in which I had participated.  Top Fed officials then rightly expressed a fear about being sued if the adopted econometric model did not have good predictive power.  It was then that I had proposed to let banks choose their own best models for estimating the charge-off and to allow regulators to impose a “capital penalty” or an appropriate extra capital requirement based on the discrepancy between the realized loss and estimated charge-off of a bank.  In fact, I had then written a memo about such a self-selection incentive compatible strategy to preserve independence of the banks and to not embroil the Fed in imposing one econometric model for all banks.[†]  This formed the basis of Basel-II.  

Can the above self-reporting approach be improved, especially with respect to nonbanks’ derivative securities?  Perhaps, yes: 

·         Fed should require nonbanks to provide a complete list of their assets and liabilities, including derivatives with corresponding values. 

·         This will result in a value of all assets including derivatives as determined by a nonbank. 

·         Since derivatives of a nonbank are claims on a counterparty (a bank or nonbank), their valuation by the counterparty can be easily reconciled by the Fed.  This is tedious but can be programmed through new derivative codes to identify the type of a derivative and its institutional underwriter.

·         The current financial market meltdown must be due to a growing difference between a nonbank’s valuation of its derivatives and its counterparty’s valuation of the same derivatives. 

·         Take for instance the CDO:  the collateral (home mortgage debt) is held by a commercial bank to lend a nonbank originator of this collateral.  The commercial bank’s valuation of the collateral based on which a margin call is issued has to be much lower than the nonbank’s valuation of the same collateral.  It is very likely that the counterparty is short in the same collateral. 

·         With its new authority, the Federal Reserve can ask for real time data from nonbanks and their counterparties to determine such discrepancy, for example, in CDO valuations.  This can accomplish two important goals: 

1.      The Fed can act preemptively to require a nonbank to have enough capital, before piling up CDOs, based on the counterparty’s (not nonbank’s) internal valuation of those CDOs.  The Fed should keep the threshold capital requirement for each nonbank confidential by not sharing it with the counterparty. 

2.      The other goal the Fed can achieve is to prevent the counterparty from making “predatory” lending to a nonbank and then to short-sell all the securities held by the nonbank for eventual liquidation of the latter.

Greed drives predatory lending. Since the Fed will set a minimum threshold capital for a nonbank and the lender of the nonbank will not know this, the greedy game of lending, short-selling securities of the borrower, and then liquidating the borrower will be eliminated. 

The recent rumors on mega failures must have originated from greedy predatory lenders who short-sold the stocks and asset holdings of the failing nonbank borrowers like Bear Stearns.  

A predatory lender can always take advantage of the information on security holdings of a vulnerable nonbank borrower to temporarily depress the values of such securities by trading on the short-side. This must have happened to Bear Stearns. A commercial bank counterparty, which is protected by the government insurance and too-big-to-fail policy, uses its power to gauze the weakness of its borrowers (nonbanks) to precipitate liquidation through short-selling of the securities held by the latter. 

If the Fed has to ultimately lend the failing nonbanks (or even households) due to a crisis orchestrated by the predatory lenders, taxpayers’ interests cannot be best served to protect predatory lending practices or to involve them in policy making. 

One can easily see why Merrill Lynch would want to merge with Wachovia: it is to protect against short-selling of its holdings by predatory lenders.  Merrill had to obtain equity capital from a sovereign country to avoid eavesdropping by the predatory lenders. 

Financial market meltdowns have occurred continually after the Glass-Stegall Act was repealed to create universal banks. Some universal banks have emerged powerful by destroying capitals of other mega banks, nonbanks and the wealth of a vast majority of American households.  The emerging mega banks have assumed the role that the Fed was mandated to play by the Federal Reserve Act.  Market-based safe banking is the only option available now to prevent financial market meltdowns.[‡] There should also be an urgent ban on short-selling of financial securities.[§]

With profound regards,

Sankarshan Acharya



[†] http://www.pro-prosperity.com/Research/BanksInternalIncentiveCompatibleLoanLossEstimate.pdf

[‡] http://www.pro-prosperity.com/Research/moralhazard-safebanking.pdf

[§] http://www.pro-prosperity.com/Research/Sub-Optimality%20of%20Short%20Selling.pdf