PARTICIPANTS
Philippe Barret, George Shultz, John Taylor, John Cogan, Gary Becker, John Gunn, John Shoven, Michael Boskin, John Ciorciari, and Matt Gunn.
KEY ISSUES DISCUSSED
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Background on Investment Banking – Philippe Barret gave a wide-ranging presentation on the investment banking industry, focusing on recent developments and relevant policy issues. He stressed that unlike commercial banks, which get much of their funding from deposits, investment banks rely on short-term wholesale borrowing, which makes their business model less durable. As support for that argument, he noted that the Bear Stearns crisis began when repo counterparties refused to accept its assets as collateral. The group discussed the Fed’s recent intervention and how the Fed’s role with respect to investment banks differs from its role as the lender of last resort to commercial banks.
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Risks in the Investment Banking Industry - In recent years, investment banks’ increasing reliance on proprietary trading for income, their rising dependency on risky “Level 3” assets for yield, and higher leverage ratios made them vulnerable to tightening credit. New products and markets also carry risks, and Barret used the booming CDS market as an example. He argued that all five major investment banks appeared to face broadly comparable risks before the Bear Stearns crisis, making it hard to predict how the subprime crisis would affect them differentially. Some analysts believed that Lehman Brothers, Goldman Sachs and others would fall like “dominoes” without the Fed’s intervention.
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Regulatory Issues – Barret described the SEC’s program to monitor the five largest investment banks as consolidated supervised entities but noted that the SEC does not publish firms’ capital ratios and liquidity data, making it difficult for investors to assess the firms’ positions or overall systemic risk in the market. He also touched on the uncertainty in markets about the Fed’s future role in the financial sector.
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Policy Options – Barret concluded by offering policy recommendations. He argued that the Fed’s recent intervention meant it would need to establish covenants with the major investment banks on capital adequacy and liquidity. Regulators also need to insist on better disclosure and mechanisms for coping with business failure. He discussed some of the challenges of effective regulation and contended that markets would solve most of the problems, as firms will deleverage, phase out complex structured products that cannot be analyzed, rely less on rating agencies, and be more cautious about counterparty risk. Interestingly, the least regulated players (hedge funds) have thus far been least damaged by recent turmoil.
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The group concluded by identifying useful areas for further research, focusing on the relationship between financial market developments (such as the growth of structured products and CDS markets) and the real economy.
