Analysis: Economic policy and the future of finance

While the world's economy has been ailing for almost two years, signs are beginning to point to recovery. Here members of the W. P. Carey School's finance faculty write about what's ahead in their fields of expertise, how the rules might be changed and what needs to be done to restore the world's economy to a healthy outlook.

While the world's economy has been ailing for almost two years, signs are beginning to point to recovery. The Conference Board announced January 26 that its Consumer Confidence index, which had improved in December, rose again in January. Three days later the Bureau of Economic Analysis reported that GDP grew by 5.7 percent in the fourth quarter of 2009.

The latest employment report shows that the number of jobs in the manufacturing sector increased. Now the U.S. and other nations are pondering how to assure that the emerging recovery is sustainable. Here members of the W. P. Carey School's finance faculty write about what's ahead in their fields of expertise, how the rules might be changed and what needs to be done to restore the world's economy to a healthy outlook.

Anand Bhattacharya, on banking regulation:

In the aftermath of the financial crises, there is a populist sentiment calling for increased regulation to manage the leverage-driven systemic risks that led to the bailout of the financial system.

As such, financial institutions will have lower levels of leverage, reduced counter party credit risk and a higher degree of aggregate transparency leading to possibly lower levels of profitability and increased degree of consolidation in the industry. However, it is important that such regulation be clearly coordinated among the various domestic and international regulators and implemented in a manner such that the regulatory requirements do not stifle financial innovation.

Werner Bonadurer, on changes in European and global banking regulation:

European Union regulators are under intense political pressure to implement far-reaching new supervisory models. They want to err on the side of too much regulation rather than too little. Higher capital and liquidity requirements for banks are necessary, and more transparency is essential, too. But many proposed rules go too far. The consequences will be costly: some rules will increase borrowing costs; banning short-selling will reduce liquidity; and standardizing derivatives will make hedging more difficult for the corporate sector.

Battles over hedge funds and executive pay have become favored talking points for politicians across Europe, but many proposed regulatory changes don't hold up to rigorous cost/benefit analysis. The new regulatory train has left the station. Its final destination is yet unclear. European Union leaders announce ambitious new regulatory schemes with gusto, but in fact these leaders resort to ambiguity when push comes to shove.

While some want a complete change in "Anglo-Saxon strategy" on financial regulations, others wish first and foremost to protect their local financial service industry or achieve a comparative advantage over rivaling financial centers. There is well-entrenched resistance to the delegation of power to a supranational body. Profound Pan-European and global regulatory coordination is easier said than done.

On the current state and future of hedge funds:

Investors learned a hard lesson. Hedge funds are not a separate asset class with rock solid diversification properties. There is no such thing as an absolute return strategy. Liquidity risk had not been compensated but, at the end, mattered most. The belief in the persistent generation of returns in excess of fair risk premiums is a fluke. Nevertheless, the future for hedge fund investing is bright, dynamic and more challenging than ever.

Successful hedge funds will operate differently than in the past. In a slower growth environment, sterling reputation, high transparency, immediate liquidity, lower leverage, proper risk management, focused product offering, broad investor base and better-aligned fee structures will become key factors for success.

As systemic risk has fallen and financial conditions have started to normalize, the correlation between risky securities prices should diminish, and the performance of individual markets and companies will become more diverse. A range of active hedge fund investment strategies will successfully employ relative value concepts. For the most immediate future, active investment strategies may well beat passive management styles.

Herbert Kaufman, on Fed policy in retrospect and prospect:

The Federal Reserve, through an unprecedented infusion of liquidity into the economy, was key in preventing a financial system meltdown and, therefore, an economic collapse. I believe the actions led by Chairman Ben Bernanke were more important than any other component of policy designed to rescue the financial system and economy. Now it appears that the financial system has stabilized and the economy has begun to recover.

The next and very important strategy decision for the Fed is when to reabsorb the unprecedented amount of liquidity that it has pumped into the economy. Its balance sheet went from about $800 billion to well over $2 trillion at its peak and has not declined substantially. It will need to take this action, once the economic recovery is secure, to prevent inflation from becoming a major problem in a few years' time.

The Fed historically has been behind the curve in terms of timing. This was the case when it increased liquidity over the last year — it should have started sooner — and, I fear, will continue to be behind the curve in draining liquidity. At least that is its track record. However, the Fed does appear from the statements of individual policymakers, including Bernanke, to recognize this danger and hopefully this will lead it to act in time.

This will have to come before evidence of a recovery and its strength is clear and, if so, it will have to brave political pressures that will suggest it has risked the nascent economic recovery. Hopefully it will have the independence, strength and judgment to do so.

Jeffrey Coles, on executive compensation:

The current debate on executive pay focuses on the wrong things. Pay practices have been blamed directly for excessive risk-taking among banking and other top executives and, accordingly, for the recent difficulties in financial markets, banking and the real economy. But the public debate does not address the characteristics of executive pay that actually lead to high-risk decisions. The source of incentives to take risks is not a new question.

Long before the recent financial crisis, my co-authors, Naveen Daniel and Lalitha Naveen, and I were working on how the structure of compensation can affect the managerial incentive to take risk. For risk incentives, it is not the level of pay or the sensitivity of pay to performance that matters.

Instead, our empirical work identifies the composition of pay — specifically managerial holdings of stock options — as a primary driver of risk. Options are important in that executives lose nothing if performance is poor, but share in the upside when a risky gamble works out. In this case, when stock performance is outstanding, executive options can deliver spectacular compensation.

This effect on risk shows up in the data. Our work indicates that more executive stock options increases both the riskiness of firm assets and volatility of stock returns. Over the last year I have been corresponding with the Obama administration's "special master" on executive pay, Kenneth Feinberg, and others in government.

I am hoping that our work leads to a focus not on level of executive pay or on the sensitivity of executive wealth to market performance but, instead, to a focus on how executive options are perhaps the most important driver of risky decisions by executives.

Karl Guntermann, on the housing and commercial property markets:

While still faltering, the housing industry is showing faint signs of life, as prices are not dropping as fast. There really a two distinct segments. Foreclosure prices appear to have bottomed out and are increasing while the foreclosure RSI is almost flat from last year, as of the preliminary numbers from December.

The non-foreclosure RSI has been declining at around 20 percent annually since the fall of 2008 and shows no signs of leveling off. The median price of non-foreclosures continues to decline. The worst appears to be past in the housing market but recovery in housing going forward will depend as much on the national and Phoenix economies as what happens to the abnormal aspects of the housing market.

While the rate of decline in single-family homes is slowing, prices of townhouses and condos are still falling. The great unknown is the continuing foreclosure problem. As for commercial, data produced so far in the ASU-RSI index show that this market is heading down. Recovery will take time.

This story originally appeared in Finance Forum (winter 2009-2010).