As Angelides pounds the gavel and adjourns the hearing, there is one question that is yet to be resolved amongst the Commission: How much of the crisis can be attributed to overarching regulatory deficiencies and how much of it can be attributed to poor risk management and incompetence by individual firms? Or are these two inextricably interconnected?
Members of the second panel testifying today point out that aside from the oft-cited ‘we let them get too big to fail’ point, there were broad regulatory failures. Eric Dinallo, for example, pointed out that the Commodity Futures Modification Act of 2000, which set into law that over the counter derivatives would not be regulated as futures or securities, may have played the biggest role in the crisis. Indeed, in a Wall Street culture that was acclimated to the idea of capital being a prerequisite of doing business, telling them essentially that they were free to use a financial instrument called a derivative without capital requirements was like giving a starved child the keys to a candy store–it only invited them to leverage up and adopt unforgivable amounts of risk.
But members of the panel also point out that firms like AIG made unique mistakes of incompetence that led to their own downfall. For example, Clarence Lee testified that a contributing factor to AIG’s liquidity crisis was that it treated its financial instruments like banking instruments–it operated as if the assets were mark-to-maturity rather than mark-to-market. This meant that AIG always had an unrealistic expectation and overvalued its assets. It was too late before it realized it would not be able to do this and suddenly fell into a liquidity crisis.
The key, of course, is to find a balance between regulating firms so thoroughly that they do not make mistakes like the one AIG made with its pricing models, but also regulating such that firms are allowed to make mistakes like the one AIG made and fall into liquidity crises without posing a systemic risk to the system. Indeed, we can’t have firms failing left and right, so while it is up to regulatory agencies like OTS to recognize serious internal problems within firms, our regulatory framework also needs to adopt a broader mindset and prepare for the failure of the firms it oversees.