For Immediate Release
Chicago, IL – December 9, 2009 – Zacks.com announces the list of stocks featured in the Analyst Blog. Every day the Zacks Equity Research analysts discuss the latest news and events impacting stocks and the financial markets. Stocks recently featured in the blog include: Goldman Sachs (GS), Morgan Stanley (MS), Bank of America (BAC), J.P. Morgan (JPM) and AIG (AIG).
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Here are highlights from Tuesday’s Analyst Blog:
Notes on William Dudley Speech
“On the liquidity front, there are a host of initiatives underway. For starters, the Federal Reserve is now supervising most of the holding companies of the systemically important financial institutions. That was not true at the start of the crisis. So, for example, the holding companies of Goldman Sachs (GS), Morgan Stanley (MS) and Merrill Lynch, which is now a subsidiary of Bank of America (BAC), are now under our direct supervision. We are making sure that they have appropriate liquidity buffers and capital.
“Second, the Federal Reserve is working with a broad range of private sector participants, including dealers, clearing banks and tri-party repo investors to dramatically reduce the structural instability of the financial system utilities, such as the tri-party repo system.
“Third, the Basel Committee is working on establishing international standards for liquidity requirements. There are two parts to this. The first is a requirement for a short-term liquidity buffer of sufficient size so that an institution that was shut out of the market for several weeks would still have sufficient liquidity to continue its operations unimpaired. The second is a liquidity standard that limits the degree of permissible maturity transformation — that is, the amount of short-term borrowing allowed to be used in the funding of long-term illiquid assets. Under these standards, a firm’s holdings of illiquid long-term assets would need to be funded mainly by equity or long-term debt.”
Mismatches between long-term assets and short-term liabilities can always create problems, but it is also a big part of the economic function of banks. Banks make most of their money (at least traditionally) by borrowing at low interest rates for short-term money (checking deposits for example) and lending at high rates long-term (a 30-year mortgage, for example).
“There is also work underway on the problem of how to ensure that financial institutions have compensation structures that curb rather than encourage excessive risk-taking. This issue of compensation is obviously a hugely potent one, as there is a fundamental unfairness in what has happened over the past few years.
“The actions taken by the Federal Reserve and others to stabilize the financial system had the effect of rescuing many of the same financial institutions that contributed to this crisis. Many of those financial institutions are now prospering, and many of their employees will be highly compensated. This situation is unfair on its face. But it is even more galling in an environment in which the unemployment rate is 10 percent and many people are struggling to make ends meet.
“Despite the fundamental unfairness of the situation, I don’t think it is feasible or practical for the Federal Reserve, or any other supervisory entity, to attempt to determine the level of compensation at individual firms on an ongoing basis. A better approach is for supervisors to ensure that a firm’s compensation regime is consistent with an institution’s safety and soundness and with broader financial stability.
“That can and should have important implications for the level of individual compensation. For example, a trader should not be paid solely on the basis of this year’s accounting profits if those profits are based on the valuation of illiquid assets held on the bank’s books that could easily go down considerably in value before they are liquidated.”
I agree that that level of micro-management is not appropriate. However, the Fed and other regulators should be able to make sure that there are not perverse incentives for bankers to take on too much risk by setting up “heads I win, tails I break even and someone else loses” compensation structures. As far as the overall level of pay is concerned, a progressive income tax is probably the best tool in that regard.
“The Fed is in the process of implementing a framework that will embed compensation practices more deeply into the supervisory process. We have made it clear to the major banks and dealers that 2009 compensation should be consistent with the recently developed Financial Stability Board principles on compensation, which emphasize the importance of appropriate incentives.
“Finally, there is considerable work underway on the ‘too big to fail’ problem. On this front, there are two main strands of work. First, we must improve the resolution mechanisms for large complex bank holding companies and nonbank financial firms that become troubled, and to complement that initiative with efforts to strengthen the financial market infrastructure. If regulators had at their disposal an effective resolution mechanism for large financial firms and the financial system was made more resilient to shocks, then the number of firms that were indeed ‘too big to fail’ would be significantly reduced.
“Second, after building such a resolution mechanism, we must still act to ensure that no special advantage persists from being perceived by creditors, counterparties and investors as ‘too big to fail.’ After all, it will be hard to build a resolution mechanism that credibly ensures that any firm will be allowed to fail under any circumstance. If there is a chance that a firm may be too big to fail, then there should be an explicit quid pro quo for that status in the form of higher capital and liquidity requirements. For example, contingent capital could be made a part of any additional regulatory capital requirements for ‘too-big-to-fail’ firms.”
The real solution to “too big to fail” is that if a firm becomes that big it really is too big to exist. Tax-free spin-offs to shareholders would be the fairest way of going about this. I would in particular like to see a return to something more like the Glass-Steagall Act, which separated commercial banks from investment banks.
However, the crisis moved us 180 degrees in the other direction as J.P. Morgan (JPM) ended up owning Bear Stearns and Bank of America ended up with Merrill Lynch. Unscrambling that egg will be tough to do. Having a resolution mechanism for such institutions is critical, so there is some path between paying everyone off at 110 cents on the dollar (for example, what happened with the AIG [AIG] counter-parties) and letting the institution collapse.
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