Professor Karl Okamoto Offers Prescription for Averting Future Financial Crises
November 13, 2008 — In the clamor to protect the country from repeating its current financial nightmare, the prospect of a new regulatory regime has become as sure as death and taxes.
But reforms will only be effective if they address the complex web of risks that underlie our financial system without dispensing medicine so strong that it kills the patient, Professor Karl Okamoto argues in a new article available for download, “After the Bailout: Regulating Systemic Moral Hazard.”
Okamoto, Director of the Earle Mack School of Law's Business and Entrepreneurship Law Program, traces the current crisis to market incentives that reward risk without imposing consequences on those who make reckless decisions. This moral hazard led to the collapse of AIG, Bear Stearns, Lehman Brothers and Washington Mutual Bank. It spilled across the entire financial system, creating a global crisis.
While it might be tempting to exact punishment on individual actors, Okamoto said financial industries require some risk in order to thrive and that market forces have tended to discourage players from acknowledging the dangers that bubble beneath some transactions.
Appearing on the Social Science Research Network (http://ssrn.com/abstract=1292476), Okamoto’s article calls for reforms such as requiring fund managers and other players to invest personal capital – “skin in the game” – or at least to disclose their own exposure – or lack of it – to discourage excessive risk taking. This disclosure would also enable institutions and individuals with fortunes at stake to make informed decisions regarding the incentives of the people they are trading with. Okamoto asserts that traditional regulatory responses like capital adequacy requirements are not enough. A requirement to maintain a specified “equity cushion” still begs the question of how to measure that cushion. Our faith in those complex calculations depends on our faith in those doing the measuring.
The article explains the conditions that led to the collapse of financial behemoths like AIG, Bear Stearns and Washington Mutual. These companies, which made their profits by investing funds borrowed at a low cost in higher-yielding assets, got into trouble by losing sight of the fact that their ability to repay loans was not their only hurdle: they needed a continuous supply of depositors, creditors and others with cash. Once the market lost faith in the risk management practices of these companies, it stopped providing the capital they required to stay afloat.
Had effective systems been in place to anticipate a worst-case scenario for asset values, the current crisis might have been averted, Okamoto said.
In the future, regulators should offer incentives to engage in predictive prevention: anticipating worst-case scenarios and putting practices in place that avoid them. Okamoto argues that by stipulating legal sanctions against primary decision-makers who fail to adopt best practices in predictive prevention, we can empower the kind of risk management practices that might avoid a crisis the next time.
Additional insights by Okamoto, Dean Roger Dennis and Assistant Professor Adam Benforado have appeared in media coverage of the emerging plans for a government rescue of financial industries.
"A Spending Wake-Up Call," an article in the Oct. 26 Philadelphia Inquirer quoted Okamoto on the benefits of rewarding consumers and taxpayers who save money.
"The Savers Should Get a Tax Break," an op-ed piece by Okamoto, director of the Business and Entrepreneurship Program, appeared in the Oct. 16 edition of the Philadelphia Inquirer.
"Bailout Opens Door for Players," Okamoto was quoted in the Oct. 12 Philadelphia Inquirer about opportunities for profiteering by companies hired to manage assets for the government.
"Skin in the Game," a commentary in the Sept. 29 Legal Times on the financial crisis by Okamoto argued in favor of greater transparency concerning the means by which the financial industry makes money.
In the Sept. 26, 2008 Livingston Daily Press & Argus and the Cincinnati Enquirer, Dennis was quoted in a story about pending criminal investigation of the financial industry "Who Will Take the Rap for the Financial Crisis?"
On Sept. 25, 2008, the Seattle Post Intelligencer published "Take the Banker’s Porsche," a guest column by Benforado, which argued that those responsible for the current financial crisis be held retroactively liable, as are the polluters who contaminated Superfund sites.
Read Okamoto’s op-ed on "Secretary Paulson's taxpayer hedge fund" in the Sept. 24 edition of the Philadelphia Inquirer.
Dennis argues that the sensible investment strategies are more important than ever amidst the financial crisis in an article that appeared in the Sept. 21 Courier Post.
Okamoto offers perspective in a Philadelphia Inquirer column that appeared on Sept. 21: Were bailouts the right thing to do?
Dennis was quoted in an article in the Philadelphia Inquirer on Sept. 17: Taxpayers have $800 billion at risk so far.
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