Conference on Regulatory Change in the Global Financial System
April 22-23, 2010

The global financial system and the world economy are still recovering from the global credit crisis which began in the spring of 2007 and continued through 2009. The sources of the crisis are many: poor mortgage lending standards, opaqueness of securitized financial products (CMOs), credit rating agencies failures, poorly capitalized banks, poorly managed OTC derivative contracts, compensation which created the wrong incentives, inadequate risk management, decline in asset prices, to name a few. It is not that we could not do better, but rather that perverse incentives riddled the financial system and a lack of transparency hid the problems.

The 23rd annual conference, sponsored by the Financial Markets Research Center (FMRC) at Vanderbilt University and held April 22 -23, dealt with the sources of the crisis and the regulatory changes that might reduce the chances of a similar crisis in the future. Participants in the conference included academics, regulators and industry leaders. As usual, the Dewey Daane Invitational Tennis Tournament took place Friday afternoon following the conference.

Jim Bradford, Dean of the Owen School, welcomed conference participants. Hans Stoll, director of the FMRC described the upcoming sessions and introduced the keynote speaker, Mark Olson, Co-Chairman of Corporate Risk Advisors, who has also held positions as Chairman of the Public Company Accounting Oversight Board, Governor of the Federal Reserve Board, and President of the American Bankers Association. Olson discussed the sources of the crisis, the recent developments in financial markets that contributed to the crisis, and the legislative process to produce a bill that may or may not be optimal.

The next session, chaired by Ron Masulis, Frank Houston Professor of Finance at the Owen School, dealt with the behavior of banks in the crisis. The first speaker, René Stulz, Everett Reese Professor at Ohio State University, gave a paper (with Andrea Beltratti), “Why Did Some Banks Perform Better During the Credit Crisis? A Cross-Country Study of the Impact of Governance and Regulation.” He found that bank performance in July 2007 to December 2008 varied cross-sectionally with the dependence on short term financing but not with differences in governance or regulation. Next, Luc Laeven, Deputy Chief of Research Division, IMF, spoke on accounting discretion of banks during the financial crisis. In a paper (with Harry Huizinga), “Bank Valuation and Regulatory Forbearance during a Financial Crisis,” he concludes that “banks overstate the value of distressed assets and their regulatory capital…” According to Laeven, the effect is that the banks’ financial health is distorted.

After a coffee break, attendees returned for a session chaired by Duke Chapman, Chairman, Prime Insurance Holdings, former Chairman of the CBOE, and a veteran of distinguished service in the securities industry. The first speaker, Bob Davis, Executive Vice President of the American Bankers Association, discussed the state of the U.S. banking system and the regulatory outlook. He supported increased capital requirements and an end to “too big to fail,” and opposed a new consumer financial protection agency. Erik Heitfield, Economist at the Federal Reserve Board spoke next on mortgage backed securities and the failure of the rating system to inform investors properly.

After lunch, in a brief interruption of the conference, Nick Bollen, Bronson Ingram Professor of Finance made a brief presentation on the Owen School’s new Master of Science in Finance (MSF) program. He noted that students in the program learn a great deal of finance in one year, and he urged attendees to hire the graduates of the program. The group then turned to the next session, “Risk Management in Practice,” chaired by Bill Christie, Frances Hampton Currey Professor of Management. The three panelists are all experienced implementers of risk management procedures. Tom Ho, president of Tom SY Ho Company and Research Professor of Finance at Owen, discussed the task his company undertook to determine the needed capital of over 800 thrift institutions regulated by the OTS. Under a contract with the OTS, the company gathered data on the assets and liabilities of each thrift and valued each asset, including those with complex option components. The minimum capital was then determined as a function of the variability of the bank portfolio. Oliver Jakob, managing director for risk control at UBS spoke about some of the complex securities that made risk control difficult. Like the other speakers, he noted the importance of involvement of senior management in risk control. Management must be willing to reject deals that do not pass the risk control screen. Chuck Lucas, who resigned as head of market risk management at AIG about 3 years ago, spoke on his experience at AIG. He noted that under Hank Greenberg, risk management was effective. After Greenberg left, operating units such as Financial Products, gained independence and paid less attention to proper risk management.

The final panel of the day, chaired by Craig Lewis, Madison Wigginton Professor of Finance at Vanderbilt, also dealt with risk and risk control. Simon Babbs, Head of Quantitative Risk Management at the Options Clearing Corporation, described risk management at the OCC. He noted that the CBOE weathered the financial crisis without great difficulty. Volume increased dramatically, but all contracts were met and only two small firms were shut down. Roy Henriksson, Chief Investment Officer of Advanced Portfolio Management Company, spoke on the lessons for risk management provided by the crisis.

The first session on Friday, chaired by Eric Noll, Executive V.P. at the NASDAQ OMX Group, dealt with developments at derivatives exchanges. John Damgard, President of the Futures Industry Association, commented on the discussions of how derivatives should be regulated and where they should be traded. He noted that the exclusivity clause of the Commodity Futures Trading Act of 1974 clarified what should be traded on organized futures markets and who should regulate the contract. Chuck Vice, President of the upstart Intercontinental Exchange (ICE), spoke on recent developments at the ICE, including advances in automation, clearing swap contracts, and other issues. Mike Cahill, President of the Options Clearing Corp, the developments in clearing new contracts, noting they are clearing equity futures products in addition to their options business.

The last session of the conference on the topic of regulatory developments was chaired by Jim Cochrane, former Senior V.P. at the NYSE. The first speaker, Jeff Harris, professor at the University of Delaware and former Chief Economist at the CFTC, discussed regulatory issues in energy markets. Jim Overdahl, Vice President at NERA and former Chief Economist at the SEC, reviewed the SEC’s short selling ban during the crisis in 2008 and concluded the ban was counterproductive.