Dodd-Frank Act - White Paper - Goldman Sachs Global Markets Institute: Effective Regulation, Parts 1-5

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In response to the financial crisis of 2008, Goldman Sachs Global Markets Institute (GMI) published a series of white papers that offered a thorough analysis the crisis. The five part series addressed the reasons behind the market meltdown, a brief history of the events leading to the crisis, and gave its recommendations as to the step that should be taken so as to avoid a repeat of such a crisis. The series in its entirety, with summaries of the key points from each part, can be found below.<ref>Effective Regulation: Parts 1 - 5. Goldman Sachs. Retrieved on February 28, 2011.</ref>

Effective Regulation: Part 1, Avoiding Another Meltdown, March 2009

In Part 1, GMI highlights the economic imbalances that led to the crisis:

  • Global savings glut "overwhelmed" housing markets;
  • Risk, as related to securitization, was "poorly managed;"
  • Increased correlation across asset classes;
  • Large, complex systemic entities exploited accounting and regulatory gaps.

Part 1 closes with an explanation of its four principles for rebuilding the global financial system:

  • Management of capital gluts and intervention in asset bubbles as they develop;
  • Augmented capital requirements for securitized loans;
  • Symmetry among lending institutions regarding the marking of loan positions; and
  • Consolidation of investment banking activities to promote "mark-to-market discipline and all regulatory and accounting rules that apply to trading assets."
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Effective Regulation: Part 2, Local Rules, Global Markets, March 2009

In Part 2, GMI argues that a regulatory overhaul is essential, and must be globally coordinated. One of the factors leading to the global imbalances highlighted in Part 1 was the notion that "capital is mobile, but regulation is local." As a result, systemically large global entities tended to seek ways to exploit regulatory gaps in what has become known as "regulatory arbitrage."

Capital markets will function best when each country's capital market is roughly the size of its economic weight. As an example, GMI lists the United Kingdom, Hong Kong, and Singapore as having developed "outsized" capital markets, and Japan and Germany as markets that are "undersized" relative to their economic weights.

GMI argues that, over the long term, capital tends to flow to entities with trustworthy legal systems, transparent markets, and clear and consistent rules. "Laxity is not a competitive advantage."

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Effective Regulation: Part 3, Helping Restore Transparency, June 2009

In Part 3, GMI offers several proposals in order to address the four principles highlighted in Part 1 above. Specifically:

  • Restrict risk transfers among affiliates such that "risks flow to entities that employ full mark-to-market accounting and on-balance-sheet reporting."
  • Do not allow affiliates to subsidize investment banking businesses by offering other financial services at below market prices.
  • Securitized loans should face, at minimum, the on-balance-sheet equivalent capital, and any securitization sold to an affiliate (rather than a true third party), shouls not qualify for regulatory capital relief.
  • Reduce the incentives for entities to transfer increasingly complex forms of risk.
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Effective Regulation: Part 4, Turning Good Ideas Into Good Outcomes, October 2009

In Part 4, GMI addresses the impending regulatory changes, and suggests that regulators must not "sow the seeds of the next crisis" in the process by diminishing market efficiency or significantly increasing costs. In addition, GMI addresses:

  • the role of market-makers in resolving mismatched markets;
  • the importance of full participation in the price-discovery process; and
  • the most effective role for central clearing entities.
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Effective Regulation: Part 5, Ending "Too Big to Fail", December 2009

In the final assessment, reform must eliminate the existence of entities that are "too big to fail." While crises will never be eliminated entirely, their frequency and severity can be substantially diminished with proper reform, and in such a way as taxpayers are no longer "on the hook."

"Contingent capital," or debt that converts to equity as a firm becomes distressed, can act as a sort of "self-insurance." But, for such a scheme to work, entities must:

  • convert to equity prior to insolvency;
  • include off-balance sheet items in risk assessments;
  • apply consistent, regular "stress tests;"
  • be highly dilutive to existing shareholders, in order to incentivize pro-active capital raising by management.
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