At Friday’s community forum, Professors Paul Glasserman, Trevor Harris and Hitendra Wadhwa (pictured at right) held an open discussion with students about how best to move forward from the financial crisis. The forum covered economic issues ranging from risk management to accounting to the importance of not allowing the near-constant stream of negative news to affect your decision making.
Professor Glasserman began the event by speaking about capital requirements for banks as they relate to the banks’ risk management practices. He offered three main points:
- Tightly linking capital requirements to risk can lead to dangerous procyclical behavior
“When a bank’s assets start to look more risky [as a result of a downturn], it must hold more capital. How does it hold more capital? It cuts back on lending. So at the worst possible time, there’s an incentive — in fact, a requirement — for banks to cut back on lending.”
To help prevent this, Glasserman suggested that banks take countercyclical measures, such as averaging out their risk over the business cycle. He also recommended that banks be required to hold additional capital in good times so that in down times there’s a buffer for them to draw on.
- Banks should continue to bear the responsibility of regulating their own risk
While it’s understandable that the recent trend of forcing banks to regulate their own risk has received a lot of criticism, Glasserman said, putting the burden back onto regulators might make matters worse.
“If you go to an environment where the regulators are specifying a very precise set of rules, you’ve created an enormous incentive for banks to manufacture products that look low-risk by regulators’ standards but are in fact high-risk in all the ways the regulators haven’t anticipated. And that’s a large part of what’s led to the current crisis.”
- Systemic risk must be factored into capital requirements
“A traditional view of risk management says, ‘What harm can the market do to me?’” Glasserman said. “When you ask about systemic risk, you’re asking, ‘What harm can I do to the market?’ It’s a fundamentally different approach, and it’s not been part of the way capital standards have been set to date.”
Professor Harris referred to the situation described by Glasserman as a “classic accounting problem.”
Harris spoke about a critical flaw in the subprime mortgage-backed securities that are a big part of the crisis, is that all parties (originators, intermediaries, investors, rating agencies and auditors) lost sight of the underlying fundamentals of people who had borrowed more than they could afford.
“My whole view is that people have forgotten fundamentals, and they’ve created lots of quant-based analytics that actually have nothing to do with reality,” Harris said. “What that leads to in many cases is the illusion of precision. We have so many techniques, including valuation techniques, to come up with point estimates, and the reality is that there’s huge amounts of uncertainty going forward, and we have to deal with that.”
He concluded, “I view [the crisis] as a great opportunity to fix a lot of systemic problems. My biggest fear is that if we come back too quickly, we won’t actually address a lot of these issues. If we don’t deal with complexity and address these fundamentals, we will actually end up in a much worse situation.”
Professor Wadhwa said that while it’s easy to allow the near-constant stream of negative economic news to affect your mood, doing so can impair your ability to make critical decisions.
“[Maintaining a positive outlook] broadens your mind, making you more aware of the periphery of whatever it is you’re looking at. It makes you more mindful of a whole range of ideas.”
To support his position, Wadhwa cited research that demonstrated a link between the mood of physicians and their ability to properly diagnose patients.
To keep yourself in a positive state of mind, Wadhwa suggested taking the following steps:
- Break the causal link between external events and your internal mood. Do this by injecting behaviors, such as displaying gratitude.
- Use humor and body language to project a positive mood not only outward but also inward.
- Turn adversity into transformational opportunities.
“Even with the constraints many of us face,” Wadhwa said, “there’s a potential for us to ask ourselves, ‘What is there within this that might be redemptive?’ By the fact that certain doors might have closed on us, we are forced out of our comfort zone to think anew about our skill set and interests and who we are.”
Photo courtesy of Columbia Business School