RSS FeedBy M. Isi Eromosele
The continuing financial crisis arose after a long and extraordinary period of growth and innovation in the global financial markets. New financial instruments enabled credit risks to be more widely spread, enabling investors to diversify their portfolios in new ways and banks to shed exposures that once stayed in their balance sheets.
Through the use of securitization, mortgages and other loans could be aggregated with similar loans and sold in tranches to a large and diverse pool of investors with differentiated risk preferences.
Through credit derivatives, banks could transfer much of their credit exposure to third parties without selling the underlying loans. This distribution of risk was widely perceived to reduce system risk, promote efficiency and to contribute to better allocation of resources.
However, instead of appropriately distributing risks, this process concentrated risk in opaque and complex ways. Innovations occurred too rapidly for many financial institutions’ risk management systems to be able to handle and for the market infrastructure, which consists of payment, clearing and settlement systems and correspondingly and for global financial supervisors.
The practice of securitization, which was supposed to break down the traditional relationship between borrowers and lenders, instead created conflicts of interest that market discipline was unable to correct. Loan originators failed to require sufficient documentation of income and ability to pay.
Securitizers failed to set high standards for the loans they were willing to buy, encouraging underwriting standards to decline. Investors were excessively reliant on credit rating agencies.
Credit ratings often failed to accurately describe the risk inherent in rated products. Lack of transparency prevented market participants from understanding the full nature of the risks they were taking.
The build-up of risk in the over-the-counter (OTC) derivatives, which were supposed to disperse risk to those most able to bear it, became a major source of contagion through the financial sector during the global financial crisis.
At Oseme Finance, we propose that the markets for all OTC derivatives and asset-backed securities be brought into a coherent and coordinated regulatory framework that requires transparency and improves market discipline.
Our recommendation would impose strict record keeping and reporting requirements on all OTC derivatives. Prudential regulation of all dealers in the OTC derivative markets should be strengthened to reduce systemic risk in these markets.
All standardized OTC derivative transactions are to be executed in regulated and transparent channels and cleared through regulated central counterparties.
We recommend that statutory and regulatory regimes be more closely aligned for futures and securities. While there are differences between securities and futures markets, many differences in regulation between the markets may no longer be justified.
Particularly, the growth of derivatives markets and the introduction of new derivative instruments have highlighted the need for addressing gaps and inconsistencies in the regulation of these products by the CFTC and SEC.
M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance
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