Bernardo M. Villegas
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A Possible Road to Redemption

           According to the "prophet of doom" that predicted the Great Recession before it happened, the advanced economies can still be "redeemed" from its current state of economic stagnation and high levels of unemployment.  Appearing before an audience of more than 600 top executives from all over the Asia Pacific region, Dr. Nouriel Roubini gave very practical solutions to the existing global economic malaise.  Since he saw the roots of the failure of market capitalism, he could recommend specific cures to the ills that he diagnosed.  We can only hope that global leaders--especially those whom he met in the recent Davos Forum, will have the political will to implement his advice.

          I had to specifically ask him about his policy advice to advanced economies because he was too busy singing praises to the Philippines and Indonesia as the two most attractive emerging markets to investors in the East Asian region.  There was no doubt in his mind that we would  soon be  getting investment grade.  He just encouraged the government leaders present in the audience to continue with improving our infrastructures, combatting corruption and taking full advantage of our demographic dividend by the appropriate human resource strategy that will significantly improve labor productivity.  My concern was about the stagnating OECD countries.  Let me expand on what he said in reply to my question by summarizing  what he wrote in his recent best-seller "Crisis Economics:  A Crash Course in the Future of Finance."  In a section entitled "The Road to Redemption," he came out with the following recommendations, among others.

    First, bankers and traders must be compensated in ways that bring their interests in line with those of the shareholders.  He made it clear that he was not suggesting a drastic cut in the compensations of CEOs and other senior executives, even if in some cases this could be desirable.  It only means that employees of financial firms should be rewarded financially in ways that encourage them to look out for the long-term interests of all the stakeholders of the firms.  In the language of a new management paradigm, they must practise what is known as "management by mission."  Going much beyond the demands of management by objectives which have led many CEOs and financial executives astray. 

          Then there must be a thorough overhauling of the securitization process.   This reform would consist of the following:  "Simplistic solutions like asking banks to retain some of the risk won't be enough; far more radical reforms will be necessary.  Securitization must have far greater transparency and standardization, and the products of the securitization pipeline must be heavily regulated.  Most important of all, the loans going into the securitization pipeline must be subject to far greater scrutiny.  The mortgages and other loans must be high quality, or if not, they must be very clearly identified as less than prime and therefore risky." We are lucky that in the Philippines securitization is still at an infancy stage in our financial sector.  There is ample time for our regulators to heed the advice of Dr. Roubini without giving up the major benefits that securitization can bestow on our capital markets.  We can still avoid "throwing the baby with the bath water."

          Our recent visiting celebrity also had very blunt advice in his book on how to regulate the likes of Standard & Poor,  Fitch, and Moody's.  Banks and other Wall Street firms were reckless in securitizing toxic assets because they were making hefty fees while passing along the risk to unwitting investors.  They could get away with this imprudence because the various ratings agencies were also making hefty fees from securitization and were more than willing to turn toxic loans into gold-plated securities that generated risk-free returns.  This was clearly a case of a blatant conflict of interest.  Unfortunately, far from criticizing this cozy relationship Federal Reserve Chairman Alan Greenspan and the "other cheerleaders" of financial innovation blessed it.   Dr. Roubini suggests that from now on, investors should be paying for ratings on debt, not the institutions that issue the debt.  Nor should the rating agencies be permitted to sell "consulting" services on the side to issuers of debt, giving rise to another conflict of interest.  Finally, the credit rating industry should be thrown open to more competition.  It has been traditionally an oligopoly.

          Other more radical reforms are needed.  Certain institutions that have long been considered as "too big to fail" must be broken up, including financial giants like Goldman Sachs and Citigroup.  Congress should resurrect the Glass-Steagal banking legislation that it repealed a decade ago.  Commercial banking should be clearly delineated from investment banking.  The renewed legislation should take into account, not only the traditional banking sector by also what is known as the shadow banking system, made up of nonbank mortgage lenders, conduits, structured investment vehicles, monoline insurers, money market funds, hedge funds, investment banks, and other entities.  These "shadow bankers" have one thing in common:  they borrow from the "depositors" who lent these entities money on a short-term basis.  The shadow banks then sank this money into illiquid, risky, long-term securities.  When panic struck this system, the depositors who had made the short-term loans demanded their money back or refused to renew loans, forcing the shadow banking system to liquidate these complex, difficult-to-value securities at fire-sale prices.

          These are only some of the major reforms recommended by Dr. Roubini to restore the U.S. economy to health.  He is realistic enough, however, to admit that the reforms he recommends can only help to reduce the incidence of crises but they will not drive them to extinction.  He opines that crises cannot be abolished; like hurricanes, they can only be managed and mitigated.  Disproving that he is a "prophet of doom" he ended his series of policy recommendations on an optimistic note.  He wrote that in the depths of the Great Depression in the 1930s, politicians and policy makers embraced reforms of the financial system that laid the foundation for nearly eighty years of stability and security.  Although it inevitably unraveled, one has to admit that eighty years of stability is a long time--actually a lifetime.  My own take is that the period of stability can even be much longer if we accompany enlightened regulation with the nurturing--through families and the educational system-- a critical mass of financial executives and businessmen who will cultivate the cardinal virtues of prudence, justice, temperance and fortitude that every human being is capable of acquiring through both his own individual effort and help of supernatural grace.   I highly recommended to the audience to read Dr. Roubini's book "Crisis Economics." For comments, my email address is bernardo.villegas@uap.asia.