How to Fix the Financial System

At his annual speech at the City Banquet at Manion House in London last night, Callum McCarthy, chairman of Britain's markets regulator, the Financial Services Authority, laid out his thoughts on how the global economic system came this close to collapse and what should be done to repair it.

To start, he made clear that he believes the problem had its roots in incompetent risk management, and the problem was widespread and pervasive.

"This is not a problem of cowboys, or fringe players. It is something which affects firms at the very core of our financial system, and it is something which requires deep and urgent attention."

An important step to restoring trust and repairing the damage is to increase transparency at banks and brokerages -- even if that means putting aside many concerns about trade secrets and other proprietary information.

"A central feature of the present difficulties has been a pervasive doubt about the position of counterparties, and a corresponding reluctance to continue to extend credit on the basis that had previously been thought appropriate. We need a more robust framework of transparency, in place and accepted before a crisis develops."

At the same time, he added, the people and institutions who buy the exotic new financial instruments at the core of the crisis must bear their share of blame for having done so negligently.

"The lessons for the buy side are of central importance: understand what you are buying; understand the limitations, as well as the strengths, of ratings; recognize that failure to conduct due diligence will have a price; recognize that covenants have a purpose, and loans without covenants carry increased risk. All these are obvious truths. The sadness is that they have so often been ignored by those who are deemed - perhaps surprisingly - to be sophisticated investors."

As others have noted, McCarthy said financial firms cannot be allowed to leverage themselves into disaster, as now appears they have done.

"We need to revisit the question of the capital banks - and, where they exist as separate entities, broker:dealers as well - must hold. ... Now, when banks face pressures of a considerable scale, is not the time to make very significant changes. But, once the present difficulties are behind us, there will be a need to re-examine - and I believe inevitably increase - regulatory capital requirements."

Lastly, he emphasized that changes need to be mapped out now, implemented as quickly as possible, and not wither and fade once the crisis has passed.

"A sea change has occurred. The fact that the full impact of its consequences cannot yet be predicted should not stop any of us from doing those things which are clearly sensible, capable of being implemented and necessary."

by Mark Stein