The Next Crisis

The New York Times had an article yesterday about the Financial Crisis Inquiry Commission report and concluded it with this paragraph:

Do further bailouts lie ahead? Neil Barofsky, special inspector general for the Troubled Asset Relief Program, seems to think so. When the government stepped in to save Citigroup in 2008, “it did more than reassure troubled markets — it encouraged high-risk behavior by insulating risk-takers from the consequences of failure,” he said in his report to Congress last week.

“Unless and until an institution such as Citigroup is either broken up, so that it is no longer a threat to the financial system, or a structure is put in place to assure that it will be left to suffer the full consequences of its own folly,” he said, “the prospect of more bailouts will potentially fuel more bad behavior with potentially disastrous results.”

It's nice to see someone talking straight.

I attended Goldman's risk committee meetings during 2000-2002, and, while I'm not a fan of everything Goldman does, they did do a very good job of limiting risk.

But they did it not with a new formula or a single rule. They did it by being smart rather than doctrinaire. They were eclectic; they had limits on all sorts of exposures -- on VaR, on the fraction of a portfolio that hadn't been modified in a year, on illiquid instruments, on estimated losses to their portfolio in a repeat of the Russian default crisis, on estimated losses in a repeat of the 1987 crash, on exposures to a single counterparty, on exposure to one emerging market currency, etc. There isn't a formula for avoiding future losses because there isn't one cause of future losses.

Going beyond Basel and its capital charges, if regulators could distill this kind of practical wisdom into a set of principles or standards for other all financial firms, banks or hedge funds, it might help minimize the size of the next crisis. Add to that an obligation to have skin in the game, a limit on size, no off-balance sheet vehicles, on-exchange trading, and a prohibition on being a market maker AND a manufacturer simultaneously (so that, to take an example from a different domain, Amazon can sell books or publish books, but not both), and perhaps the next crisis will be smaller.