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March 20, 2009

Moving Forward from the Crisis

Brian Belardi
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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:

  1. 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.

  2. 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.”

  3. 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:

  1. Break the causal link between external events and your internal mood. Do this by injecting behaviors, such as displaying gratitude.
  2. Use humor and body language to project a positive mood not only outward but also inward.
  3. 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

Comments

by Deependra Chaudhry | March 22, 2009 at 8:52 AM

I would like to congratulate the professors for not only their pertinent views but also for the diverse angles from which they approached the problem. I found points 2 and 3 made by Prof. Glasserman of particular interest. Besides being important, they also connect with Prof. Wadhwa's and Prof. Harris's comments. In case of point 2, we must not allow the current criticism of banks to diminish our optimistic mood. The tug-of-war between regulation and de-regulation will always persist, but we must be optimistic in order to find an innovative solution and hence find middle ground. Prof. Glasserman's third point ties in wonderfully into Prof. Hariss's comment on systemic problems. I agree that adequate time should be given to address these systemic problems, which will no doubt entail a paradigm shift in our understanding and approach to the same such as the one mentioned by Prof. Glasserman. My only disagreement is with Prof. Glasserman's first point. Although I agree, in-principle, to the view of averaging out capital holdings over a business cycle, I am not sure whether this is possible in the long-run or even at all. The problem lies with the socio-economic structure of our society. In times of economic boom, banks tend to be more lenient in granting loans, as was the case a few months back. Additionally, there is pressure on the government to relax monetary policy to enable greater lending, especially if the boom is perceived to be long-lasting. The government obliges by relaxing ratios like statutory liquidity, cash reserve and repo/reverse repo rates. It is the quantum of relaxation that is of importance. Too much can cause a glut, while too little can nip economic growth. We are seeing a rather extreme practical example of such a process right now, especially in the Indian scenario, where the govt. carried out gradual relaxation in monetary policy right up to the onset of the global economic crisis. Consequently, private banks have frozen their lending and it is the state-owned banks which are being mandated to carry the lending torch forward. For instance, one finds strong presence of this phenomenon in the Indian automobile sector (http://www.livemint.com/2009/02/20224611/SBI-freezes-rate-for-auto-loan.html). I would like to know whether Prof. Glasserman believes the fundamental phenomenon of business cycles / inflation-deflation can be overcome given the socio-economic structure of society in general. If not, then through what mechanism can high-precision monitoring and correction be brought about between monetary policy and private lending practices so as to cushion economies almost completely and avoid the present turmoil in future.

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