Contributors: John E Core, Wharton School, University of Pennsylvania ◆ Christopher C Geczy, Wharton School, University of Pennsylvania ◆ Wayne R Guay, Wharton School, University of Pennsylvania ◆ Tetsuya Kamiyama, Nomura Institute of Capital Markets Research ◆ Kei Kodachi, Nomura Institute of Capital Markets Research ◆ Alan McIntyre, Oliver Wyman Group ◆ Michael Zeltkevic, Oliver Wyman Group YASUYUKI FUCHITA is a senior managing director at the Nomura Institute of Capital Markets Research in Tokyo He coedited Prudent Lending Restored (Brookings, 2009) with Richard J Herring and Robert E Litan and Pooling Money (Brookings, 2008) with Litan RICHARD J HERRING is the Jacob Safra Professor of International Banking and professor of finance at the Wharton School, University of Pennsylvania, where he is also codirector of the Wharton Financial Institutions Center ROBERT E LITAN is a senior fellow in Economic Studies at the Brookings Institution and vice president for research and policy at the Kauffman Foundation His many books include Good Capitalism, Bad Capitalism, and the Economics of Growth Prosperity (Yale University Press, 2007), written with William J Baumol and Carl J Schramm NOMURA INSTITUTE OF CAPITAL MARKETS RESEARCH Tokyo www.nicmr.com/nicmr/english Cover design and illustration montage by Claude Goodwin BROOKINGS / NICMR BROOKINGS INSTITUTION PRESS Washington, D.C www.brookings.edu After the Crash In After the Crash, noted economists Yasuyuki Fuchita, Richard Herring, and Robert Litan bring together a distinguished group of experts from academia and the private sector to take a hard look at how the financial industry and some of its practices are likely to change in the years ahead Whether or not you agree with their conclusions, the authors of this volume—the most recent collaboration between Brookings, the Wharton School, and the Nomura Institute of Capital Markets Research—provide well-grounded insights that will be helpful to financial practitioners, analysts, and policymakers Fuchita / Herring / Litan A s the global economy continues to weather the effects of the recession brought on by the financial crisis of 2007–08, perhaps no sector has been more affected and more under pressure to change than the industry that was the locus of that crisis: financial services But as policymakers, financial experts, lobbyists, and others seek to rebuild this industry, certain questions loom large For example, should the pay of financial institution executives be regulated to control risk taking? That possibility certainly has been raised in official circles, with spirited reactions from all corners How will stepped-up regulation affect key parts of the financial services industry? And what lies ahead for some of the key actors in both the United States and Japan? After the Crash The Future of Finance Yasuyuki Fuchita, Richard J Herring, and Robert E Litan, Editors AFTER THE CRASH 00-0404-1 fm.indd 7/12/10 5:58 PM 00-0404-1 fm.indd 7/12/10 5:58 PM yasuyuki fuchita richard j herring robert e litan Editors After the Crash The Future of Finance nomura institute of capital markets research Tokyo brookings institution press Washington, D.C 00-0404-1 fm.indd 7/12/10 5:58 PM Copyright © 2010 the brookings institution nomura institute of capital markets research All rights reserved No part of this publication may be reproduced or transmitted in any form or by any means without permission in writing from the Brookings Institution Press After the Crash: The Future of Finance may be ordered from: brookings institution press c/o HFS, P.O Box 50370, Baltimore, MD 21211-4370 Tel.: 800/537-5487; 410/516-6956; Fax: 410/516-6998 Internet: www.brookings.edu Library of Congress Cataloging-in-Publication data After the crash : the future of finance / Yasuyuki Fuchita, Richard J Herring, and Robert E Litan, editors â•…â•… p.â•… cm â•… Includes bibliographical references and index â•… Summary: “Examines the ramifications of the 2007–08 financial crisis on the financial services industry and some of its practices and how these are likely to change in the future”— Provided by publisher â•… ISBN 978-0-8157-0404-1 (pbk : alk paper) â•… Financial institutions.╇ Financial institutions—Deregulation.╇ Financial services industry.╇ Financial crises—United States—21st century.╇ Financial futures.╇ I Fuchita, Yasuyuki, 1958–╇ II Herring, Richard.╇ III Litan, Robert E., 1950–╇ IV Title â•… HG173.A38╇ 2010 â•… 332.1—dc22 2010026369 987654321 Printed on acid-free paper Typeset in Adobe Garamond Composition by Cynthia Stock Silver Spring, Maryland Printed by R R Donnelley Harrisonburg, Virginia 00-0404-1 fm.indd 7/12/10 5:58 PM Contents Preface After the Crash: Will Finance Ever Be the Same? 83 Christopher C Geczy Is There a Case for Regulating Executive Pay in the Financial Services Industry? 53 Kei Kodachi and Tetsuya Kamiyama The Future of the Hedge Fund Industry 11 Alan McIntyre and Michael Zeltkevic Regulatory Changes and Investment Banking: Seven Questions Yasuyuki Fuchita, Richard J Herring, and Robert E Litan The Uncertain Future of U.S Commercial Banking vii 115 John E Core and Wayne R Guay Contributors 141 Index 143 v 00-0404-1 fm.indd 7/12/10 5:58 PM 00-0404-1 fm.indd 7/12/10 5:58 PM Preface I n 2004 the Brookings Institution joined with Nomura Institute of Capital Markets Research to showcase research on selected topics in financial market structure and regulation of interest to policymakers, scholars, and market practitioners in the United States and Japan, as well as elsewhere Initially led by Brookings senior fellow Robert E Litan and Yasuyuki Fuchita, senior managing director of Nomura Institute of Capital Markets Research, the collaboration was joined in 2008 by Richard J Herring of the Financial Institutions Center at the Wharton School of the University of Pennsylvania A conference has been convened each year since 2004, leading to four volumes published by Brookings Institution Press, most recently Prudent Lending Restored: Securitization after the Mortgage Meltdown (2009).1 The chapters in this fifth volume in the series are based on presentations made at a conference, After the Credit Crash: The Future of Finance, held on October 16, 2009, at the Wharton School in Philadelphia The conference considered the future of the financial services industry after the crisis of 2007–08 and focused on commercial banks, investment banks, and hedge funds in particular All of the chapters represent the views of the authors and not necessarily those of the staff, The first five of these conferences were sponsored by the Tokyo Club Foundation for Global Studies (now part of Nomura Foundation) and the Brookings Institution vii 00-0404-1 fm.indd 7/12/10 5:58 PM viii preface officers, or trustees of the Brookings Institution, the Nomura Institute of Capital Markets Research, or the Wharton Financial Institutions Center The editors thank Adriane Fresh for research assistance and for checking the factual accuracy of the manuscript; Diane Hammond for careful editing; and Lindsey Wilson for organizing the conference and providing administrative assistance Both the conference and this publication were funded in part by Nomura Foundation 00-0404-1 fm.indd 7/12/10 5:58 PM yasuyuki fuchita richard j herring robert e litan After the Crash: Will Finance Ever Be the Same? T he financial crisis of 2007–08, which led to what is now known as the Great Recession of 2008–09, will go down in history as one of the most troubling economic events of the postwar era Although some prescient analysts forecast that the housing bubble in the United States, which triggered the crisis, eventually would burst, we suspect that few foresaw the crisis bringing the United States and other global economies nearly to their knees Certainly, no mainstream forecaster or high-profile policymaker predicted this outcome Even now, after the dust has settled somewhat and a halting recovery is under way, many questions about the future of the global financial services industry remain After receiving massive government infusions of capital and experiencing large numbers of failures, what will the U.S commercial banking industry look like in the years ahead? Further, with only one major independent investment bank left in the United States after the crisis, what impact will new regulations have on the investment banking business, under whatever corporate structure it is conducted? The same question can be asked of the hedge fund industry, which went into the crisis largely unregulated And finally, what is the evidence that the executive compensation structures of some financial companies contributed to the crisis (a criticism leveled by regulators and many in the media)? Should compensation regulation be imposed on the financial services industry? And if so, what form should it take? 01-0404-1 chap1 7/12/10 4:48 PM 138 john e core and wayne r guay equity incentives, there is no clear evidence that U.S CEOs receive significantly more risk-adjusted pay than U.K CEOs.31 It appears to us that most of the recent regulations and proposals regarding executive compensation proposed by Treasury Secretary Geithner and implemented by Special Master Feinberg are based on arguments from only the side of the debate that asserts that U.S pay is too high and that U.S performance incentives are too low As we note above, these arguments have little empirical support Geithner’s proposed principles to guide executive compensation seem noncontroversial, in the sense that it is difficult to argue with the principles as stated and also that many or most firms already appear to design compensation practices to conform to such principles Of more concern, however, are the rules for implementing the principles, as proposed by Feinberg Some of the requirements are reasonable, in that most firms already follow them or in that it is sensible—or not costly—to adopt them These requirements include compensation committee independence, clawbacks, reduced perquisites, and tax gross-ups More concerning are restrictions on severance and change-in-control payments and on the level and composition of executive compensation and incentives Evidence suggests that the typical firm uses severance and change-in-control payments efficiently; removing them from the risky and financially unhealthy TARP firms seems only to make it more difficult for these firms to attract and retain good talent The same is true for restrictions on executive pay and incentives U.S executives hold more equity performance incentives than executives in any other country, so it is difficult to argue that they not have enough incentives Further, and particularly in light of these incentives, there is no evidence that U.S executives are systematically overpaid Finally, although it is reasonable for regulators to be concerned about risk-taking incentives for executives, there is often confusion over what constitutes risk-taking incentives as well as a failure to recognize that some risk taking is necessary to compete effectively within any industry Although the language of regulators nearly always states that there is a dual goal (better aligning compensation practices with the interests of shareholders and promoting the financial stability of firms; see the statements by Geithner above), how regulators prefer to implement these goals can differ from shareholders’ preferences And it may be that the final implementation emphasizes the stability and low risk taking favored by government claimholders over the value creation favored by stockholders 31 Conyon, Core, and Guay (2009) 05-0404-1 chap5.indd 138 7/12/10 6:06 PM regulating executive pay in the financial services industry? 139 References Bebchuk, L., and J Fried 2004 Pay without Performance: The Unfulfilled Promise of Executive Compensation Harvard University Press ——— 2009 “Paying for Long-Term Performance.” Working Paper Harvard Law School Bhagat, S., and R Romano 2009 “Reforming Executive Compensation: Simplicity, Transparency, and Committing to the Long-Term.” Working Paper Yale University Coles, J., N Daniel, and L Naveen 2006 “Managerial Incentives and Risk-Taking.” Journal of Financial Economics 79 Conyon, M., J Core, and W Guay 2009 “Are US CEOs Paid More than UK CEOs? Inferences from Risk-Adjusted Pay.” Working Paper University of Pennsylvania Core, J., W Guay, and R Thomas 2005 “Is CEO Compensation Inefficient Pay without Performance?” University of Michigan Law Review 103 Core, J., W Guay, and R Verrecchia 2003 “Price versus Nonprice Performance Measures in Optimal CEO Compensation Contracts.” Accounting Review 78 Drucker, J 2008 “PNC Stands to Gain From Tax Ruling—Acquisition of National City Will Bring Billions in Deductions, Experts Say.” Wall Street Journal, October 30 Eisfeldt, A., and A Rampini 2004 “Letting Go: Managerial Incentives and the Reallocation of Capital.” Working Paper Northwestern University Fahlenbrach, R., and R Stulz 2009 “Bank CEO Incentives and the Credit Crisis.” Working Paper OSU Fisher College of Business Ferri, F and D Maber 2008 “Say on Pay Vote and CEO Compensation: Evidence from the UK.” Working Paper Harvard University Frydman, C., and R Saks 2007 “Executive Compensation: A New View from a Long-Term Perspective, 1936–2005.” Technical Report 2007-35 Federal Reserve Board Gabaix, X., and A Landier 2008 “Why Has CEO Pay Increased So Much?” Quarterly Journal of Economics 123 Graseck, B., and C Pate 2009 “Bank of America Quick Comment: Catalyst #1 Comes through; TARP Repayment a Big Positive.” Morgan Stanley Research North America Guay, W., 1999 “The Sensitivity of CEO Wealth-to-Equity Risk: An Analysis of the Magnitude and Determinants.” Journal of Financial Economics 53 Hall, B., and L Liebman 1998 “Are CEOs Really Paid Like Bureaucrats?” Quarterly Journal of Economics 113 Inderst, R., and H Mueller 2005 “Keeping the Board in the Dark: CEO Compensation and Entrenchment.” Working Paper New York University Jensen, M., and W Meckling 1976 “Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure.” Journal of Financial Economics Jensen, M., and K Murphy 1990 “Performance Pay and Top-Management Incentives.” Journal of Political Economy 98 Ju, N., H Leland, and L Senbet 2002 “Options, Option Repricing, and Severance Packages in Managerial Compensation: Their Effects on Corporate Risk.” Working Paper University of Maryland/University of California at Berkeley Kaplan, S 2008 “Are U.S CEOs Overpaid?” Academy of Management Perspectives 22 Kaplan, S., and J Rauh 2009 “Wall Street and Main Street: What Contributes to the Rise in 05-0404-1 chap5.indd 139 7/12/10 6:06 PM 140 john e core and wayne r guay the Highest Incomes?” Review of Financial Studies Advance Access (http://rfs.oxfordjournals org/cgi/content/abstract/hhp006) Lambert, R., D Larcker, and R Verrecchia, 1991 “Portfolio Considerations in Valuing Executive Compensation.” Journal of Accounting Research 29 Laux, V 2005 “Board Independence and CEO Turnover.” Working Paper Frankfurt: Goethe University Myers, S 1977 “Determinants of Corporate Borrowing.” Journal of Financial Economics Murphy, K 1999 “Executive Compensation.” In Handbook of Labor Economics, edited by O Ashenfelter and D Card Vol Amsterdam: North-Holland Parrino, R., and M Weisbach 1999 “Measuring Investment Distortions Arising from Stockholder-Bondholder Conflicts.” Journal of Financial Economics 53 Piketty, T., and E Saez 2003 “Income Inequality in the United States, 1913–1998.” Quarterly Journal of Economics 118 05-0404-1 chap5.indd 140 7/12/10 6:06 PM Contributors John E Core Wharton School, University of Pennsylvania Tetsuya Kamiyama Nomura Institute of Capital Markets Research Yasuyuki Fuchita Nomura Institute of Capital Markets Research Kei Kodachi Nomura Institute of Capital Markets Research Christopher C Geczy Wharton School, University of Pennsylvania Robert E Litan Kauffman Foundation and Brookings Institution Wayne R Guay Wharton School, University of Pennsylvania Alan McIntyre Oliver Wyman Group Richard J Herring Wharton School, University of Pennsylvania Michael Zeltkevic Oliver Wyman Group 141 06-0404-1 bm.indd 141 7/12/10 6:09 PM 06-0404-1 bm.indd 142 7/12/10 6:09 PM Index ABCP See Asset-backed commercial paper Accounting: accounting standards, 68; fair value accounting, 59, 106–07; international reporting standards, 65–66; off-balance-sheet entities, 68 After the Credit Crash: The Future of Finance (conference; 2009), vii, 1–2 AIG, 2, 70, 127 AlphaClone, 100 Arbitrage: convertible arbitrage, 94, 95; fixed-income arbitrage, 88, 95; merger arbitrage, 94, 99; regulatory arbitrage, 4, 64, 65–66, 78 Asia, 67 Asset-backed commercial paper (ABCP), 56 Assets: asset levels, 106; bank trading-book holdings, 64–65; fair-market accounting and, 59; fair value of, 106; long-term assets, 16, 25, 56, 60, 66; marking to market of, 106; price effects and margin spirals, 58–59; risk-weighted assets, 65; strategic asset allocation, 104; value of, 57 See also Banks and banking; Hedge funds; Statement of Financial Accounting Standards Auction settlement, 72 Bank of America, 2, 4, 40, 42, 127 Bank of China, 78 Banks and banking: assets of, 55–56, 57, 58, 59, 64, 65, 66; bailouts and, 12; bank branches, 21, 26, 47, 48; bank failures, 49; bank holding companies, 4, 27; banking crisis of 1930s, 14; borrowing by, 57, 66; business models of, 14–15, 27, 28, 47–48, 49, 79; capital levels and, 30, 32, 43, 44, 47, 54–61; cash, checks, and debit cards, 21, 22, 23, 31; CEO compensation in, 120–25; changing environment for U.S commercial banking, 29–51; competition, 32–33; cost efficiency and cost control, 47–49; definition of, 120; deposits, 18, 20–21, 26–27, 33, 44–47, 66–67; deterioration of performance of, 2–3, 11; in emerging market economies, 67; equity levels, 15; financial crisis of 2004–09, 24–27, 28, 54, 56, 61–62; funding of bank positions, 56, 66; future scenarios of, 3, 11, 12–13, 28–51; “gap” investments and earnings, 18, 24, 42; golden era of (1993–2003), 2, 11, 12, 16–24, 30, 42, 45, 48; growth rates of, 26–27; historical 143 06-0404-1 bm.indd 143 7/12/10 6:09 PM 144 performance of, 13–27; human capital in, 49–50; institutional positioning of, 39–42; investment banks and banking, 3–4; management execution by, 42–51; mergers and acquisitions, 21, 22, 49; purchase of Treasuries, 30; recession of 1981 and, 15; regulation of, 12, 13, 15, 18, 21, 28, 30–32, 33, 35, 37, 40; regulatory arbitrage by, 64; revenues of, 13, 15, 19, 40, 41; risks of, 42–44; S&Ls/ thrifts (savings and loan banks), 16, 17, 27, 28, 49; shadow banking sector, 12, 27, 30, 32; targeted asset growth, 43–44; value at risk, 62–64 See also Economic issues; Loans and lending; Nonbanks; Securities and securitization; individual banks by name Banks and banking—fees: commercial banking revenues and, 13, 25–26, 40; deposit fees, 23–24, 30–31, 33, 42; financial crisis and, 11–12; free checking and, 21; during the golden era, 18, 19, 23; penalty fees, 23–24; role in banking industry business model, 14–15, 16; transaction account fees, 45 Banks and banking—profitability: analysis of scenarios, 33–37, 38–39; during the financial crisis, 2004–09, 27; future profitability, 28; during the golden era 1993–2003, 16–18; during the period 1980–92, 15–16; range of industry profitability, 13; rate-sensitive funding and, 42; regulation and, 12, 30, 32; service charges/fees on deposit accounts and, 23–24 Banks and banking—recommendations for: compensation and human capital, 50; cost controls, 49; country-specific leverage, capital requirements, 4; general description of, 4, 78; higher capital charges, 4; higher capital standards, 4, 60–61; innovation, 50–51; leverage quality, 66–67; limitation of kinds of assets, 4; management of deposits business, 46–47; mergers and acquisitions, 49; risk management, 4, 42, 06-0404-1 bm.indd 144 index 62–64; targeted asset growth, 44; tradingbook assets, 64 Barclays (Lehman) aggregate bond index, 88 Basel I, 61 Basel II: capital framework, 4; in China, 78–79; framework for market risk, 61–62; regulatory arbitrage and, 65; Basel III funding rules, 32, 46 Basel Accord of 1988, 61 Basel Committee on Banking Supervision (BCBS), 61, 62, 64, 78, 79 Bear markets, 91–92 Bear Sterns, 3–4, 24, 106 Bond indexes, 95 Bond markets, 54–55, 92 See also Treasury, Department of the Brazil, 79 Broadmarket Prime, 108–09 See also Madoff, Bernard Brokers, 58 Brookings Institution, vii–viii, Bull markets, 90–91, 92 BXM index, 94 Capital: asset prices and, 58; capital adequacy rules, 65–66, 77; capital markets, 67; capital requirements for trading books, 61–65; cyclicality of regulatory capital framework, 62; financial crisis of 2007–09 and, 57; firesale externality and regulatory capital, 59–61; Long-Term Capital Management crisis of 1998, 55; value-risk-based capital adequacy ratios, 65 See also Banks and banking Casey, Quirk, and Associates/Bank of New York survey, 84 CBOE See Chicago Board Options Exchange CDSs See Credit default swaps CEO compensation See Compensation standards and structures CFTC See Commodity Futures Trading Commission Chan, N., 95 Chen Siqing, 78 7/12/10 6:09 PM index Chicago Board Options Exchange (CBOE), 95 China, 78 China Banking Regulatory Commission, 79 Chrysler Financial, 127 Chrysler Group LLC, 127 Clearinghouses, 72, 75, 110 Clinton, William J (“Bill”), 115 Citigroup, 127 Commerce (de novo bank), 26 Commodity Futures Trading Commission (CFTC; U.S.), 71, 110 Compensation standards and structures: as asset-management fee, 118; better disclosure of executive incentives, 137; CEO compensation, 7–8, 49, 115, 121–25; compensation committees, 127, 128, 138; components and definitions of, 119, 120, 122–25; debate over, 116–17; financial crisis and, 7, 49, 126; firm size and, 118; flaws in the pay-setting process, 117, 126–27; of financial institutions, 7; for hedge and equity funds, 7, 8; nonbinding say-onpay shareholder votes, 134–35; periodic assessment of risk-taking incentives, 135–36; political factors of, 126; regulation of, 7, 8–9, 115–16, 117, 120, 125–37; recommendations for, 126–27, 137; subordinates’ compensation, 131; Treasury proposals for, 127–28 Compensation standards and structures— specific: bonuses, 127, 128–29; clawback provisions, 127, 132, 138; earnings management incentives, 127; equity options, 116; equity performance incentives, 119; measurement of performance incentives, 121; performance incentives, 122, 124, 125, 126, 129–32, 135, 137–38; perquisite compensation, 127, 133–34, 138; restrictions on salary, bonus, and option payments, 128–32; risk-taking incentives, 121, 127, 133, 135–37, 138; severance and change-incontrol payments, 127, 132–33, 138; stocks and stock options, 116, 117, 121, 06-0404-1 bm.indd 145 145 122–25, 127, 128–31; tax gross-ups, 127, 133–34, 138 Compensation standards and structures— U.S.: benchmarking of U.S executive pay, 117–20; executive pay in the U.S financial sector, 120–25; regulation of executive pay, 125–37 Competition See Economic issues Consumers, 26, 31, 43 Core, John, 7, 115–40 Credit cards See Loans and lending Credit default swaps (CDSs), 69, 70–73 See also Derivatives Credit markets, 72–73 Credit ratings, 67, 72 Credit Suisse, 88–87, 90 Credit Suisse indexes, 89, 92 Debit cards See Banks and banking Debt: collateralized debt obligations, 62, 66, 69, 71; distressed debt as level assets, 107; structured subprime debt, 89 De novo banks, 26 Derivatives: derivatives portfolio replication, 98–99; risks and regulation of, 5, 70–73, 87; trading of, 110; use of, 73 See also Credit default swaps; Structured investment products Developing countries, 78 See also Emerging market economies Dot.com bubble, 24 EAFE Ex Japan index, 92 Economic issues: balance sheet factors, 13–14; changing macroeconomic environment for U.S commercial banking, 29–30; competition, 12, 13, 20, 26, 31, 32–33, 43, 45, 128; costs of regulation, 31; deposits, 20–21; economic cycles, 62; economic stress, 62–64; GDP (gross domestic product), 14; household debt, 18–19; income inequality, 116; inflation, 12, 15, 29–30; interest rates, 14–16, 18, 19–20, 24–26, 29, 42, 45, 55; leverage and leveraging, 17, 32; marketoriented systemic risk, 54–55; maturity 7/12/10 6:09 PM 146 transformation, 56; recessions of 1981, 1991–92, 2008–09, 15, 16, 29 See also Banks and banking; Compensation standards and structures; Financial crisis of 2004–09 Emerging market economies, 67, 79 See also Developing countries Endowments, 100, 101t, 102–03 Equity indexes, 90 Equity markets, 89, 91–92, 93, 95 EU See European Union Eurex Clearing, 71 Europe, 58, 68, 76 See also individual countries European Commission, 63, 67, 71 European Union (EU), 76–77, 110 See also individual countries Exchange-traded funds (ETFs), 96, 98 Execucomp database (S&P), 120 FASB See Financial Accounting Standards Board FDIC See Federal Deposit Insurance Corporation Federal Deposit Insurance Corporation (FDIC), 14, 27, 32, 45, 135 Federal Reserve, 2, 24, 32, 76 Federal Reserve Bank, 15, 30, 33 Fees, 7, 84, 85, 86 See also Banks and banking—fees Feinberg, Ken (Special Master for TARP Executive Compensation), 8, 127–28, 129–31, 136, 138 Financial Accounting Standards Board (FASB), 106–07 Financial crisis of 2004–09: bank losses and, 61, 64; casualties of, 2–5, 28, 89; compensation and, 7, 8; deposits and, 26–27; effects of, 29–37, 59; financial crisis after 2007, 27; G-20 reforms and, 53–79; lending and, 25–26; recovery from, 12, 29, 35, 90; Treasury effects, 24–25 Financial crisis of 2004–09—background and causes of: analysis by the G-20, 54; banking problems, 24–25, 65, 66; crisis 06-0404-1 bm.indd 146 index after 2007, 27; deposits, 26–27; Federal Reserve, 24–25; hedge funds, 5, 76, 77, 89–90, 91–93, 111; lending, 25–26; over-the-counter derivatives, 70, 71–72; prediction of, 1; short selling, 73, 74; subprime mortgage problem, 67; turmoil in liquidity markets, 56–57, 59 Financial holding companies, 31 Financial services, 8, 12, 32, 116 Financial Services Authority (U.K.), 75 Financial Services Oversight Council (U.S.), 76 Financial Stability Board, 78 Financial Stability Forum, 64 Financial systems, 55 Fire-sale externality, 59–60 Foreign banks, 26 Foreign Corrupt Practices Act (1977), 31, 32 France, 76 Frank, Barney (D-Mass.), 71 Fuchita, Yasuyuki, vii, 1–9 Funds of funds, 85, 86, 87, 89, 96–97, 98, 111 Fung, W., 105 Futures markets, 87, 95, 99 GDP (Gross domestic product) See Economic issues Geczy, Christopher, 5, 6–7, 83–113 Geithner, Timothy (secretary, U.S Treasury), 8, 125–26, 138 General Motors Co., 70, 127 Germany, 76 Glass-Steagall Act (1933), 14 GMAC Inc., 26, 127 Gold, 95 Goldman Sachs, 4, 45, 98 Great Recession of 2008–09 See Financial crisis of 2008–09 Gross domestic product (GDP) See Economic issues Group of Twenty (G-20), 4, 53–54, 76 Guay, Wayne, 7, 115–40 “Haircuts,” 56, 57, 59, 66 Harvard, 100 7/12/10 6:09 PM index Hedge funds: aggregate hedge fund portfolios, 94, 95; asset prices and, 58; benchmarks of, 93–94, 95–96, 111; business model of, 111; definition of hedge funds, 83; in diversified portfolios, 89–93, 97; effects of hedge fund trading, 77; fees and costs for, 7, 84, 85, 86, 87, 96–97, 105, 111, 118; financial crisis and, 5, 77, 89–90, 91–93, 111; future of, 5–6, 7, 94, 111; hedge (in hedge funds), the, 89, 93; hedge fund indexes, 88–89; investors in, 85–86, 87, 91–92; issues and trends revealed by hedge-fund survey, 84–88; liquidity in, 77–78, 84, 86, 87, 95; lock-ups, 6, 86; managers and management of, 99–100, 104–05, 110, 111, 118; marking-to-market of, 106–09; operation and performance of, 6, 84, 93–94, 97, 102, 111; provisions and characteristics of, 6, 90; recommendations for, 88, 111; registration of, 76, 109–10; regulation of, 76–78, 85, 87, 96, 109–10; reporting, 87, 109–10; risk factors of, 6, 85, 86, 87, 89, 96, 104, 109; selection and survivor biases, 105; spreads of, 94; trackers, 96–99, 100–04; trading strategies and, 85, 87–88, 94, 95, 96–105, 111; transparency in, 84, 85, 87, 96, 111; typology of, 6; volatility of, 89–93, 102 Hedge funds—value of: aggregate hedge fund index returns, 88; aggregate hedge fund portfolio multiple-factor contemporaneous market beta, 94; alpha, 104–05, 111; exotic beta, 94–96, 104; factor exposure, 93; factor models, 93–94; general factors, 88; market or factor timing, 105–06; replication, 87, 96–105; vanilla beta, 88–93, 103 Herfindahl-Hirschman Index, 22 Herring, Richard, vii, 1–9 Housing issues, 1, 2–3 ICE Clear Europe, 71 IMF See International Monetary Fund IndexIQ, 98 India, 79 06-0404-1 bm.indd 147 147 IndyMac, 27 ING Direct, 26 Internal Revenue Code, 115 International Accounting Standard 27, 68 International Monetary Fund (IMF), 65 International Organization of Securities Commissions, 78 International Swaps and Derivatives Association, 72 Internet, 26 Investment Advisers Act of 1940, 76 Investment banks and banking See Banks and banking Investment Company Act of 1940, 83, 96, 97 Investor Protection Act of 2009, 68 Investors, 5–6, 85 See also Hedge funds; Pension funds Kamiyama, Tetsuya, 4–5, 53–81 Kat, H., 99 Kodachi, Kei, 4–5, 53–81 Korea, 79 Lehman Brothers, 2, 3–4, 58, 72–72, 89, 106 Leverage, 58, 65–67 Liabilities: bank assets and, 56, 60; deposit liabilities, 45, 46f; hedge fund industry stress and, 111; level assets and, 106; long-term assets and short-term liabilities, 15–16, 25, 27, 56, 66; market liabilities, 45 Liquidity: bank trading books and, 64–65; hedge funds and, 77–78, 84; marketability and, 66; maturity transformation and market liquidity, 54–56; turmoil in liquidity markets, 56–58, 59–60 Litan, Robert, vii, 1–9 Loans and lending: bank lending, 43–44; credit card lending, 19–20, 30, 44; demand for loans, 19–20, 43; financial crisis of 2004–09 and, 24, 25–26, 54; home equity lending, 19; real estate lending, 19–20; regulation of, 30; risk 7/12/10 6:09 PM 148 issues, 19, 42; U.S credit liabilities, 26 See also Banks and banking; Securities and securitization Loans and lending—mortgages: financial crisis of 2004–09 and, 67; leading lenders, 40, 42; origination fees from, 40; subprime and alt-A mortgage lending, 2–3, 25–26, 42, 54, 67 Lobbies and lobbying, 31 London Stock Exchange, 77 See also Stock markets Long-Term Capital Management, 78 Luo Ping, 79 Madoff, Bernard, 96, 108–09 Margins, 57, 58–59 Market timing, 104–05 Marking to market, 95, 106, 107–09 McIntyre, Alan, 2, 3, 11–51 Merrill Lynch, 2, 4, 62 Merrill Lynch factor model, 97, 98 Metropolitan statistical areas (MSAs), 39–40, 41 Mexico, 79 Money market funds, Morgan Stanley, Mortgages See Loans and lending— mortgages MSAs See Metropolitan statistical areas Mutual funds, 56, 96, 98, 118 NACUBO-Commonfund Study of Endowments, 100 Naked short selling See Short selling New York Stock Exchange (NYSE), 77 See also Stock markets Nomura Institute of Capital Markets Research, vii–viii, Nomura Securities, Nonbanks and nonfinancial firms, 4, 26, 33, 121, 123 See also Investment banks and banking NYSE See New York Stock Exchange Obama, Barack H (D-Ill.; president), 116, 134 06-0404-1 bm.indd 148 index Over-the-Counter Derivatives Markets Act of 2009, 71, 110 See also Derivatives Ovitz, Michael S., 133 Pastor-Stambaugh liquidity benchmark, 95 Pension funds, 6, 85–86 See also Investors Peterson, Collin (Democratic-Farmer-Labor Party-Minn.), 71 Ponzi schemes, 96, 108–09 Princeton, 100 Private equity firms, 118 Private equity funds, 76, 77 Private funds, 76, 87 Private Fund Investment Advisers Registration Act of 2009, 76 QAI portfolio, 98 Rajan, Raghuram, 60 Recommendations See Banks and banking—recommendations; Compensation standards and structures; Hedge funds; Rules and regulations— recommendations “Reform Pay Practices for Top Executives to Align Compensation with Long-Term Value Creation and Financial Stability” (press release; Treasury), 129 Regulations See Rules and regulations Rehypothecation, 58, 60, 61 Replication, 87, Repurchase (repo) market, 56–58, 59, 66, 68 Risk and risk management: commercial banking and, 42; concentration risk, 70; credit default swaps and, 72; credit risk, 42, 61, 65; default risk, 62; equity risk, 119, 131; fair-market accounting and, 59; in hedge funds, 6, 85, 86, 87, 96; incremental risk charge, 61–62; idiosyncratic risk, 93; investor views of, 85; liquidity risk, 42, 56; manager risk, 96; market and market-oriented risk, 54–55, 58, 60, 61, 93; measuring risk of investments, 93; operational risk, 61, 96, 109; risk-adjusted CEO compensation, 7/12/10 6:09 PM index 119; risk-taking CEO compensation incentives, 121, 127, 133, 135–37, 138; stressed value-at-risk measure, 61–62; subprime mortgages and, 56; systemic risk, 76, 77, 93; value at risk, 62–64 Robertson, Julian, 100 Rules and regulations: accounting standards, 68; circuit breaker rules, 73, 75; compensation rules, 126–37; costs of, 31–32; disclosure requirements, 68; fire-sale externality and regulatory capital, 59–61; percent risk-retention rule, 68; of hedge funds, 76–78, 85, 87, 96, 109–10; Investor Protection Act of 2009, 68; leverage ratios, 66–67; market risk rules, 62–64; off-balance-sheet vehicles, 68; over-the-counter derivatives, 70–73; regulation E (Federal Reserve), 31; regulatory arbitrage, 4, 64, 65–66, 78; risk retention rules, 68; short selling, 73–76; structured-product markets and, 67–70; subprime mortgage problem and, 67; uptick rules, 73–74, 75, 110 Rules and regulations—recommendations: general financial regulation, 79; G-20 recommendations, 4; hedge funds, 77–78; over-the-counter derivatives, 71–73; risk retention rules, 68–70; short-selling, 74–76 Russia, 79, 105 Safe harbors, 83, 97 S&P (Standard & Poor’s) 500 index, 88–89, 90–91, 95, 118 Sarbanes-Oxley Act of 2002, 132 Sato, Takafumi, 79 SEC See Securities and Exchange Commission Securities Act (1933), 83 Securities and Exchange Commission (SEC): credit default swaps and, 70, 71; disclosure of compensation arrangements, 137; discovery of fraud by, 96, 109; enforcement by, 109, 110; fair value accounting and, 106–07; Over-theCounter Derivatives Markets Act and, 71; 06-0404-1 bm.indd 149 149 registration and operational requirements and, 76, 87, 109–10; short selling and, 73, 75–76, 110; uptick rule and, 74, 110 Securities and securitization: asset-back securities, 57, 62, 66; bank borrowing and, 57, 66; as bank collateral, 59; bank profitability and, 18, 19; charges on securitization exposure, 61; credit default swaps and, 72, 73; financial crisis of 2004–09 and, 25–26; funding of bank positions and, 56; goals and growth of, 19, 69; regulation of, 5, 69–70; resecuritization exposure, 62; risk diversification effect of, 68; short selling and, 75; as a source of credit, 69; subprime mortgage lending and, 2–3 See also Structured investment products Securities Exchange Act of 1934, 58 Securities Investor Protection Act (1970), 58 SFAS 157 See Statement of Financial Accounting Standards 157 Shareholders: in the banking industry, 11, 15, 27, 49; CEO compensation and, 125, 126, 127, 137, 138; change-in-control agreements and, 133; equity holdings and, 136; of private equity funds, 77; sayon-pay votes of, 8–9, 116, 134–35 Sharpe ratios, 90, 91, 92, 102 Short selling, 4, 5, 73–76, 77, 87, 89, 110 Standard & Poor’s See S&P Statement of Financial Accounting Standards 157 (SFAS 157): adoption of, 106–07; fair valuation principles of, 87, 106; hedge funds and, 6–7; importance of, 96 Stock markets, 54, 70, 73, 74, 75, 77, 118 Structured investment products, 56, 67–70 See also Derivatives; Securities and securitization Supervisory Capital Assessment Program (2008), 27, 32 TARP See Troubled Asset Relief Program Tax deductions for CEO compensation, 115 Thomson Financial and Nelson, 84 Tiger Cubs (funds), 100 7/12/10 6:09 PM 150 TIPS (Treasury inflation-protected securities) See Treasury, Department of the Trackers See Hedge funds Trading books, 64–65 Treasury, Department of the: bank capital levels and, 60; bond yields and rates of, 15, 18; inflation-protected securities (TIPS), 29; limitation of executive compensation by, 8, 136; sale of distressed firms, 133; value at risk and, 64 See also Geithner, Timothy; Finberg, Ken; Troubled Asset Relief Program Treasury inflation-protected securities (TIPS) See Treasury, Department of the Troubled Asset Relief Program (TARP), 8, 27, 49, 127, 132, 135, 137 “Turner Review” (UK), 69 index United States (U.S.), 29, 58, 67, 117–37 See also Securities and Exchange Commission; Treasury, Department of€the University of Pennsylvania, 100 U.S See United States Volatility index (VIX), 95 Volcker, Paul, 15 Washington Mutual, 21, 27 Wells Fargo, 40, 42 Wharton Financial Institutions Center, vii–viii, Wharton Hedge Fund Survey of Pension Consultants, 84–88, 110 Yale, 100 United Kingdom (U.K.), 58, 118–19, 137–38 06-0404-1 bm.indd 150 Zeltkevic, Michael, 2, 3, 11–51 7/12/10 6:09 PM Brookings Institution The Brookings Institution is a private nonprofit organization devoted to research, education, and publication on important issues of domestic and foreign policy Its principal purpose is to bring the highest quality independent research and analysis to bear on current and emerging policy problems The Institution was founded on December 8, 1927, to merge the activities of the Institute for Government Research, founded in 1916, the Institute of Economics, founded in 1922, and the Robert Brookings Graduate School of Economics and Government, founded in 1924 Interpretations or conclusions in Brookings publications should be understood to be solely those of the authors Nomura Foundation Nomura Foundation is a nonprofit public interest incorporated foundation which aims to address social and economic issues involving Japan and the rest of the world by devoting private sector resources to promote international exchanges and the interchange between social science theory and practice The foundation also provides grants and scholarships to support the social sciences, arts and culture, and up-and-coming international artistic talent In the area of World Economy Research Activities it sponsors research, symposiums, and publications on current trends in capital markets of advanced and emerging economies as well as on topical issues in global macroeconomic stability and growth It relies on a network of institutions from Europe, the United States, and Asia to assist in organizing specific research programs and identifying appropriate expertise Nomura Institute of Capital Markets Research Established in April 2004 as a subsidiary of Nomura Holdings, Nomura Institute of Capital Markets Research (NICMR) offers original, neutral studies of Japanese and Western financial markets and policy proposals aimed at establishing a market-structured financial system in Japan and contributing to the healthy development of capital markets in China and other emerging markets NICMR disseminates its research among Nomura Group companies and to a wider audience through regular publications in English and Japanese Wharton Financial Institutions Center, University of Pennsylvania The Wharton Financial Institutions Center is one of twenty-five research centers at the Wharton School of the University of Pennsylvania The Center sponsors and directs primary research on financial institutions and their interface with financial markets The Center was established in 1992 with funds provided by the Sloan Foundation and was designated as the Sloan Industry Center for Financial Institutions, the first such center designated for a service-sector industry It is now supported by private research partners, corporate sponsors, and various foundations and nonprofit organizations The Center has hundreds of affiliated scholars at leading institutions worldwide, and it continues to define the research frontier, hosting an influential working paper series and a variety of academic, industry, and “crossover” conferences 06-0404-1 bm.indd 151 7/12/10 6:09 PM Contributors: John E Core, Wharton School, University of Pennsylvania ◆ Christopher C Geczy, Wharton School, University of Pennsylvania ◆ Wayne R Guay, Wharton School, University of Pennsylvania ◆ Tetsuya Kamiyama, Nomura Institute of Capital Markets Research ◆ Kei Kodachi, Nomura Institute of Capital Markets Research ◆ Alan McIntyre, Oliver Wyman Group ◆ Michael Zeltkevic, Oliver Wyman Group YASUYUKI FUCHITA is a senior managing director at the Nomura Institute of Capital Markets Research in Tokyo He coedited Prudent Lending Restored (Brookings, 2009) with Richard J Herring and Robert E Litan and Pooling Money (Brookings, 2008) with Litan RICHARD J HERRING is the Jacob Safra Professor of International Banking and professor of finance at the Wharton School, University of Pennsylvania, where he is also codirector of the Wharton Financial Institutions Center ROBERT E LITAN is a senior fellow in Economic Studies at the Brookings Institution and vice president for research and policy at the Kauffman Foundation His many books include Good Capitalism, Bad Capitalism, and the Economics of Growth Prosperity (Yale University Press, 2007), written with William J Baumol and Carl J Schramm NOMURA INSTITUTE OF CAPITAL MARKETS RESEARCH Tokyo www.nicmr.com/nicmr/english Cover design and illustration montage by Claude Goodwin BROOKINGS / NICMR BROOKINGS INSTITUTION PRESS Washington, D.C www.brookings.edu After the Crash In After the Crash, noted economists Yasuyuki Fuchita, Richard Herring, and Robert Litan bring together a distinguished group of experts from academia and the private sector to take a hard look at how the financial industry and some of its practices are likely to change in the years ahead Whether or not you agree with their conclusions, the authors of this volume—the most recent collaboration between Brookings, the Wharton School, and the Nomura Institute of Capital Markets Research—provide well-grounded insights that will be helpful to financial practitioners, analysts, and policymakers Fuchita / Herring / Litan A s the global economy continues to weather the effects of the recession brought on by the financial crisis of 2007–08, perhaps no sector has been more affected and more under pressure to change than the industry that was the locus of that crisis: financial services But as policymakers, financial experts, lobbyists, and others seek to rebuild this industry, certain questions loom large For example, should the pay of financial institution executives be regulated to control risk taking? That possibility certainly has been raised in official circles, with spirited reactions from all corners How will stepped-up regulation affect key parts of the financial services industry? And what lies ahead for some of the key actors in both the United States and Japan? After the Crash The Future of Finance Yasuyuki Fuchita, Richard J Herring, and Robert E Litan, Editors ... Kamiyama of the Nomura Institute examine the future of the investment banking business through the lens of eight major regulatory changes that, at the time of the conference, were contemplated by the. .. years b) a The Herfindahl-Hirschman index (HHI) is defined as the sum of the square of market shares times 100 The index is calculated at the level of the core-based statistical area (CBSA) for... declared bankruptcy, after Merrill Lynch fled to safety in the arms of Bank of America, after the Federal Reserve improvised an unprecedented bailout of the creditors of AIG, and after the U.S Treasury