Regulatory lessons from sub prime crisis

What are the regulatory lessons from the sub-prime crisis? In the barrage of comment, I flagged the following:

• Liquidity risk needs more attention than hitherto
• Rating of securitisation tranches needs to be put under the scanner
• How much of securitisation is permissible- and how much of the loans should remain with the originator- may need thinking through
• We need better pricing of risk although where the models have gone wrong is not clear
• Greater transparency is required in respect of derviatives exposures- in credit default swaps, for instance, the total volume of contracts written on an underlying credit must be known

Fair enough but let me mention two others that I think require even closer attention. One is higher capital at banking. In my ET column, Revisiting bank regulation, I argue that this is required not so much for the conventional reason, as a first line of defence against risk, but for containing incentives in banking. High leverage is creating incentives for managers to take undue risks and one way to rein this in is to impose a higher capital requirement.

But this is not enough. We need a more direct attack on incentives- and this may require regulatory action because I doubt that the banking industry will want to do anything about it once the crisis blows over. I have written about this in earlier posts but, very briefly, three steps are in order:

• the magnitude of bonuses needs to be contained
• bonuses at the top must be in the form of stock options that vest over a period of at least five years
• bonuses must not be paid out in full for a given year of performance; a big percentage must be held over for, say, five years and it must be used for adjustment against any losses that a manager inflicts on the bank.