Fall 2008 Workshop & Lecture Series Law & Finance Tuesday, October 7, 2008 Corporate Governance Standards and Financial Crises Regulatory Failures & Policy Responses Gerard Hertig

October 7, Agency Issues Regulation: What May Matter for Financial Stability Board powers, composition, structure Accounting standards and disclosure Managerial compensation Audit Firm architecture & risk management Credit rating constraints State bail-out and deposit insurance Supervision

October 7, Contributing to / Not Preventing the Current Financial Crisis Passive boards “Mark to market” accounting Information asymmetries Flawed compensation incentives Regulatory arbitrage distortions Risk management break-downs Conflicted rating agencies Passive supervisors

October 7, Risk Management Break-Down Normal times Oblivious to growth of traded credit products Excessive reliance on external ratings Failure to detect ineffective hedges Inadequate analysis of firm-wide exposure Extreme events Liquidity assumed in VaR models Low priority stress testing and scenario analysis Keeping the wrong crises in mind (LBOs/80s, emerging markets/90s, hedge funds/98)

October 7, CGS Policy Response Framework Basics It is not all about CG Beware of easy targets (e.g. compensation) Dealing with the current mess vs. Regulating the future Extreme events may be a bridge too far Regulatory diversity did not seem to make a difference Insurance companies did not do better Hard to lean against the wind when crises are far apart Could the current crisis mislead us? New regulation now or later? Forgoing reforms is not an option No urgency + Risk of unintended consequences Regulatory momentum + Regulatory erosion

October 7, Main Proposals & Trade-Offs I Increasing Transparency Improving fair value accounting for financial holdings Suspending mark-to-market in thin markets (“fire sales”) but then what: Mark-to-model? Discounted cash-flows? Trigger for review and reserve but what about hidden reserves and managerial slack? Better reporting of exposures and valuation methods Providing more information but was lack of information that much of an issue? Revealing trading positions but best liquidity providers = Least transparent ones?

October 7, Main Proposals & Trade-Offs II Toughening capital adequacy Leverage ratio: Own funds as a % of assets but does one-size-fit-all? Did ≠ make a ≠? “Greed” ratio: Own funds as a % of gross revenue but does more revenue mean more risk? Building up liquidity reserves in good times but this is playing in the hands of managers Capital charges for securitized assets (EU, not US) but what standardization and alternatives (issuer rating)? Complexity and regulatory capture

October 7, Main Proposals & Trade-Offs III Improving credit rating regulation Removal of rating-based regulation (U.S. + EU) Reduces incentives to game ratings Limitation of investment choice/diversification? Assumes more astute institutional investors? Moving towards supervision (especially EU) Supervision was a major failure in the current crisis Leading to centralization of supervision in the EU? Will regulation kill efforts to foster rating competition?

October 7, Main Proposals & Trade-Offs IV Improving supervision Supervisory centralization (US) and cooperation (EU) Economies of scope/scale and intensity of supervision Who will contribute to bail-outs? Politics? Good governance for supervisory bodies “Public entity” model vs “Firm” model Accountability vs. independence Monitoring law-making Regulatory cartels