Blankfein Part II: Regulation

Earlier, I considered Goldman Sachs CEO Lloyd Blankfein's comments about Wall Street compensation from a speech (opens .pdf) he gave today at a financial conference in Germany. Now I'd like to move onto his thoughts on financial regulation. Despite the sensational aspect of the bonus talk, I believe that the regulation portion is far more important. As I've noted a few times, the cause of the financial crisis had little to do with Wall Street bonuses. So I'm a lot more interested in what Blankfein thinks about regulation. He outlines several suggestions, which I'd like to comment on.

He begins by conceding that the some financial innovation lost sight of practicality causing needlessly complex derivatives to flourish. Blankfein then says:

That is one reason why Goldman Sachs supports the broad move to central clearing houses and exchange trading of standardized derivatives. Clearly, there is general agreement on the necessity of central clearing for derivatives. A central clearing house with strong operational and financial integrity will reduce bi-lateral credit risk, increase liquidity and enhance the level of transparency through enforced margin requirements and verified and recorded trades. This will do more to enhance price discovery and reduce systemic risk than perhaps any specific rule or regulation.

I agree, and I think most of the financial community does too. He goes on to explain that the question of which derivatives can be exchange-traded isn't clear-cut. That's true, and will prove challenging for regulators to grapple with.

After his complex securities talk, he delves into consideration of a systemic risk regulator. He's for it. That's completely expected: as a large systemically important institution, Goldman Sachs would be better off with such a regulator in place. Since a systemic risk regulator would have as hard a time predicting sudden, unexpected market shocks as everyone else, its job would likely be to insure that no institution like Goldman fails. No one should be surprised to see that Blankfein would support an entity that would help to insure his firm's survival.

He makes a few more interesting assertions related to systemic risk:

First, all of the exposures of a financial institution should be reflected through the P&L.

He goes on to specifically take issue with off-balance sheet entities. That had long been one of the attractive characteristics of securitization. It allowed issuers to take assets off their balance sheet, after they were securitized. Regulators were already moving in this direction before the crisis, much to the dismay of that industry. Blankfein appears to support that change.

Would it have prevented the crisis? Probably not. By the time shocking numbers of mortgages started going bad, most of the mortgage companies that created them (Ameriquest, New Century, etc.) had already failed or been absorbed by bigger entities (Countrywide, etc.) due to what was on their balance sheet -- not what wasn't. You could argue that investors might have thought twice about putting their money in the stock of such companies if everything had been disclosed on their balance sheets, but I doubt it. The problem was that everybody misread the market, so knowing more about these assets likely wouldn't have made a difference.

Overall though, such a regulatory change wouldn't be a bad idea, depending on how it was actually implemented and interacted with existing requirements.

Second, in addition to requiring that all risk flow through the P&L, all assets across a
systemically important financial institution should be valued correctly.

This is the important one. He's coming out in favor of mark-to-market requirements. He also claims Goldman already goes above and beyond when it comes to marking their assets to the market. It's interesting to hear a major bank CEO support mark-to-market for all assets, though not altogether shocking, given that Goldman is his bank. He has far less to lose right now compared to some other banks, especially if his firm truly does conservatively mark-to-market already. The banks this would really affect are those who have large portfolios of real estate or other hard-to-value assets that would have to immediately incur gigantic losses if illiquid assets were suddenly subject to new market-based valuation requirements.

I agree that all assets should be marked-to-market. It seems completely logical that investors (and regulators) should have a way to better compare the value of a financial institution's assets to other firms without having to worry about internal assumptions. Transparency is definitely good for the market in the long-run.

Third, regulators need to more regularly and proactively engage market participants.

This is an amusing one, because he essentially means that regulators are asking the wrong questions. He suggests they ask stuff like:

"Where are standards slipping or policies being stretched? Where are pressures building up? And, where are you seeing concentrations in risk?"

Perhaps regulators worry about the accuracy of the answers they'd get if they ask financial institutions such questions? I know I would. But sure, I can agree with the general point that regulators should be proactive. Everybody else probably does too.

And fourth, coordination among regulatory agencies should improve -- not just between
countries but within them.

Again, this one is kind of a no-brainer, and seems completely uncontroversial. It also speaks to the point that regulators need to do better. No argument here from me.

All in all, this speech by Blankfein is an interesting one, given his prominent position. He didn't really have to say some of what he did. Even though he probably cares about the public's perception of Goldman Sachs, it's still the most respected bank in the industry. It's not like its reputation on Main Street could do much damage to its potential profits. That's why I almost wonder if he could be setting the stage for a future political career. The yellow-brick road from Goldman to Washington is well-worn -- just ask former Treasury Secretaries Henry Paulson or Robert Rubin. Perhaps one day there will be a Treasury Secretary Blankfein as well.