Article provided courtesy of Futures Industry Magazine, March/April 2009 Issue
Can we prevent another financial crisis like the one we are now experiencing? Part of the answer is to analyze what went wrong, but history has shown that this is not enough. The lessons of past financial crises, no matter how painful at the time, tend to fade over time as markets return to normal and a new generation of traders, bankers and regulators rises to the top.
What we clearly need is a permanent structure to identify problems in the financial sector and make sure that the lessons learned become permanently embedded in market practices. Andrew Lo, a professor at the Sloan School of Management at the Massachusetts Institute of Technology, has proposed an interesting solution to this problem. In testimony before the House Financial Services Committee last fall, he called for establishing a permanent, independent government agency modeled on the National Transportation Safety Board to study failures in the financial markets. As a former financial markets regulator, I think that this idea deserves serious consideration by policy-makers as they develop a new architecture for financial markets regulation and oversight.
The NTSB is an independent agency governed by a five member board appointed by the President. It maintains a permanent, expert staff to investigate and report on every civil aviation accident in the U.S. and significant accidents in other forms of transportation. Its accident reports, which are compiled into a database that is accessible to the public, contain factual information pertaining to the conditions and circumstances under which the accidents occurred as well as analyses, conclusions and probable causes. The NTSB has issued more than 12,000 recommendations, many of which have been incorporated into industry safety standards and designs, resulting in a steady improvement in transportation safety over the years.
For example, the NTSB is currently investigating the crash of US Airways flight 1549 on Jan. 15, 2009. Although this crash fortunately resulted in no loss of life among the passengers or crew, a team of experts are thoroughly examining the wreckage to analyze the engine problems that forced the plane into the Hudson River. In less than 30 days, the NTSB not only had confirmed that the birds sucked into the aircraft’s engines were Canada geese, but also had identified a potential flaw in the manufacturing standards for the engines used on this aircraft. These standards, which were certified in 1996, require that the engines continue generating thrust after ingesting a bird that weighs up to four pounds, well below the typical size of an adult Canada goose.
The US Airways pilots and crew have been rightly praised for their skill in landing the plane and saving the passengers, but in the long run the NTSB’s work in dissecting the causes of the engine failure may well save far more lives. Although financial market disasters may not be readily susceptible to NTSB-style forensic investigation, there is an equally valid argument for on-going review and analysis by an independent, well-funded government agency.
First and foremost, having such an agency would inform policy making so that the regulatory fixes under consideration would actually address the identified problems. Secondly, by institutionalizing this function, studies of smaller market events could be undertaken before they mushroom into larger ones. Thirdly, an independent watchdog would be more likely to spot inter-market issues and bring a fresh perspective to the issue. Finally, making this a permanent feature of the regulatory landscape could ensure a continual process of addressing shortcomings and making market structures more resilient. At the very least, each agency should be required to investigate every serious failure in its jurisdiction.
The Shortcomings of the Ad Hoc Approach
That is not to say that there have not been reviews of market problems in the past. To the contrary, there are many fine examples of the good that can come out of expert, thorough reviews of market problems. For example, following the stunning collapse of Barings PLC in 1995, the Futures Industry Association organized the Global Task Force on Financial Integrity to identify ways to improve industry practices. The task force’s recommendations, once adopted, helped strengthen market infrastructures, making them more resistant to subsequent stresses.
Another example is the Presidential Task Force on Market Mechanisms, generally known as the Brady Commission, which was formed in 1987 in the wake of the Oct. 19 stock market crash. The commission’s report detailed the causes for the crash by examining the interrelationships among the stock, futures, and stock options markets and reconstructing the performance of market specialists, options market makers and local traders in the futures markets. Many of its recommendations, including circuit breakers and the timing of final contract settlement, have become a part of the fabric of the markets.
While studies like these have resulted in important changes in the regulatory framework for futures trading, there are serious shortcomings with this ad hoc approach. For one thing, the insights that are developed during the course of one agency’s study are not necessarily shared with all other financial regulators. This is especially problematic when interrelationships among markets may have been at the core of the market failure. For another thing, there is no continuity over time. The group of experts formed to draft the study disbands once the effort is concluded, leaving it to the next study to reassemble the necessary expertise.
Equally critical is the choice of what gets studied. Private sector studies by industry associations, trade groups and various think-tanks are dependent upon the organization’s ability to fund particular projects. Ironically, the more pervasive the market failure, the fewer the resources that may be privately available to fund the project. Perhaps just as decisive, the more pervasive a market problem, the less time and attention private sector leaders may have to organize industry-wide review initiatives. Finally, privately sponsored studies may face difficulties in obtaining access to certain types of information that would be made available to an official inquiry.
Ad hoc government studies have their own limitations. Often studies have been undertaken as a result of the political process, and certain topics-such as problems in the operational infrastructure of markets-generally have not commanded the attention of lawmakers. In addition, a single-agency study mandated by Congress is unlikely to focus on issues arising from inter-market relationships or market structures outside the agency’s jurisdiction. And cross-agency studies are susceptible to the jockeying of the constituent agencies based upon their perceptions of how the study fits into each agency’s larger mission-related goals.
Over the course of my career at the Commodity Futures Trading Commission, I was involved in a number of congressionally mandated or agency-sponsored studies. These included a study of trading on material, non-public information in the futures markets, a study of progress toward electronic trading and related improvements in automated audit trails, and a study of OTC agricultural options. I also chaired the CFTC Task Force on Regulatory Reform, the recommendations of which were adopted by Congress in 2000 as the principles-based regulatory framework that applies to futures exchanges and clearinghouses today.
The work we did in these studies produced tangible results that helped improve the regulatory structure for U.S. futures markets, but the benefits might have been greater if they were part of a more systematic and sustained effort. While the futures industry has been fortunate in that the failures of the last several years did not pose systemic risk issues anywhere near the magnitude of the Lehman or AIG catastrophes, without a thorough, expert analysis of each failure and a public discussion of its causes, the lessons of these disasters may be misapprehended or worse, forgotten over time.
The current financial crisis makes it all the more critical to establish an independent, NTSB-like agency for the financial system. In addition to all the problems discussed above, it is clear that the entire landscape of financial regulation is undergoing profound change. The roles of various existing regulators are evolving rapidly, with many set to take on new functions or expanded responsibilities. In addition, the fact that the government has taken ownership stakes in various financial institutions may create new obstacles for regulators to conduct truly independent analyses of any future financial disasters involving those institutions.
The new NTSB-like agency should have authority to investigate and report publicly on any major financial failure in which funds are lost in excess of a set amount. Moreover, it should be able to launch inquiries involving lesser losses if they implicate the jurisdiction of more than one regulator or involve entities that are exempt from regulation. The new agency should make its recommendations public, and it should have the authority to order the financial regulators to act if particular recommendations require cross-agency cooperation to implement. Finally, in light of the globalization of the financial markets, the agency should be authorized and encouraged to cooperate with financial regulators in other jurisdictions. Although it would be ideal if a government agency could anticipate the next risk which will arise to the financial system, it would be foolish if we do not at least erect a framework that will help us to avoid repeating past mistakes by systematically uncovering their causes. As the work of the NTSB demonstrates, incremental changes consistently undertaken over time can have profound results. Surely, if we have learned nothing else from the current financial crises as it is unfolding, it is that we have no single, independent and authoritative source to sift through and extract the valuable lessons that remain hidden in the debris.
Editor’s note: for a more detailed description of Andrew Lo’s proposal, see pages 18-21 of his November 2008 testimony at http://oversight.house.gov/documents/20081113101922.pdf
Paul Architzel ispartner in the financial services and products practice of Alston & Bird. His practice includes counseling and representation of exchanges, clearing organizations, commission merchants, advisers, traders, hedge funds and others with respect to commodity law compliance. Prior to joining Alston & Bird, Architzel was chief regulatory counsel of Eurex US from 2003 to 2006. He was also chief counsel of the CFTC’s Division of Market Oversight (formerly the Division of Economic Analysis) for over 20 years. The views stated are those of Paul Architzel and not those of Alston & Bird, LLP.