Regulatory Reform: Lessons From Recent Events – Disclosure About Liquidity

Treasury Secretary Henry Paulson outlined a broad financial regulatory plan that reportedly has been in the works for over one year. While the plan may not be a reaction to recent market turmoil, it comes on the heals of extraordinary steps such as the Fed-engineered buy out of Wall Street giant Bear Stearns by JPMorgan Chase.

The proposed regulatory plan is a good first step. It recognizes the need for an overhaul of the current alphabet soup of financial regulators. Many of those regulators were an outgrowth of a bygone era, the great depression. As such, they tend to reflect a market structure and way of doing business which existed during that time period more closely than they today’s market conditions.

At the same time redoing financial regulators to reflect current market conditions is hardly a new idea. This is not the first time, for example, that there have been proposals to merge the SEC and CFTC. At the same time, many of the ideas in the proposal are constructive, such as eliminating multiple banking regulators and making explicit the expanded role the Fed is currently serving in the markets. While the notion of regulatory overhaul might not be new, perhaps its time has finally come.

At the same time it seems clear that any debate over regulatory reform – and clearly Secretary Paulson’s proposals will only be the beginning – should carefully consider the causes of the current market turmoil. Those causes are just now starting to emerge and be understood.

Nevertheless, two lessons from the current market crisis seem clear. First, regulatory capital is not a solution to current market issues. Capital is maintained by firms such as Bear Stearns. The SEC has regulations dealing with the question which are supposed to help ensure the financial integrity of the institution. Right up to the moment that Bear Stearns was sold, the firm assured the markets that it was in full compliance with capital requirements. Days before its sale, the firm issued a press release assuring the markets. The SEC’s Division of Market Regulation issued a press release noting that Bear’s filings showed the firm was in full compliance with capital requirements. The staff’s release sought to reassure the markets by asking and answering common questions on the issue

Regulatory capital does not equal liquidity, however. As SEC Chairman Cox’s letter of March 20, 2008 to the Basel Committee on Banking Supervision made clear, the hasty sale of Bear was the result of a lack of confidence which caused liquidity issues, not any lack of capital. Financial services firms and in fact any professional services firm is largely a function of confidence and liquidity that is faith and cash flow from creditors who have faith in the firm. When, for example, Arthur Anderson collapsed in the wake of criminal charges or, years ago when once powerhouse Wall Street player Drexel went under, it was a lack of liquidity stemming from a lack of faith by creditors that caused the collapses. So too with Bear Stearns. The firm had capital. It did not have confidence and liquidity.

This presents the second issue – transparency. Much of Bear’s liquidity was tied to creditors holding short term financial instruments for which there are few disclosure requirements. Absent disclosure, it is difficult for investors and the markets to fully assess liquidity and thus viability as the Bear situation demonstrates. Indeed, this lack of transparency can lead to unnecessary concern among creditors from lack of knowledge or unfounded rumors, all of which can spiral into instability.

At the same time, there are reports that the SEC is investigating trading in Bear Stearns’ securities shortly prior to the sale to determine if there was insider trading. While the precise reasons for that trading have yet to be determined, one possible explanation is that it reflects the knowledge of Wall Street professionals in the derivative markets who many have suspected the nature of the investment bank’s financial difficulties from their knowledge of the markets. This, of course, is trading on a shrewd guess, not insider trading.

Regardless of the outcome of the SEC’s inquiry however, it is clear that what the markets knew was regulatory capital, not liquidity. This suggests that any call for regulatory reform should start with better transparency of key financial information impacting liquidity. While the SEC has emphasized the question of cash flows over the years in its MD&A requirements, the tale of Bear’s demise demonstrates that that there is far too little known by the markets about the key subject of liquidity and the complex financial arrangements which control it.