Are the days of the financial lottery over? Is the excitement (and at times envy or disdain) of seeing a CEO or hedge fund manager make a killing a thing of the past? A new era of public ownership, and subsequent public oversight, may be signaling the end of the financial superhero (see WSJ article). The involvement of the Treasury in nearly every aspect of the financial system certainly means more oversight, more regulation, and more required regulatory capital: and of course, lower returns and paydays. The end result may be a slow stumble to the middle. Boring may in fact turn out to be better in the long-run, but suffering through another post-excess 1930s or 1970s market while Wall Street once again finds its way is not going to generate the page turning excitement of reading about your favorite superhero (or villain).

The Financial Services Authority (FSA) in the UK is planning to conduct a "significant reappraisal" on how banks use securitization to free-up capital (see Financial Times article) given that mortgage bonds and other asset-backed securities are becoming more complicated than originally believed. This is important for US investors given that the FSA is the leading voice on the Basel Committee. Adjustment beyond current Basel II regulations and guidelines are already being discussed with regard to raising bank capital requirements. The problem is that as new products are developed, it is difficult to know exactly what risk are being created for all counterparties. Since the risk is often managed at the point of origination, or sold off, there has at times been less interest in formally quantifying the risk, leaving counterparties on the other side with a product that is less understood than others in terms of market and credit risk exposure.

One person close to the issue was quoted as saying that securitization of ordinary loans turned out to be "considerably more complicated than originally thought." Yes, but in many cases it was not that they were more risky than previously calculated, but that the risk was never really calculated or considered in the first place. As risk was sold off and transferred, there was often an assumption that someone else was bearing the risk. In the end, the risk was not only larger than some predicted, but it was not transferred to others as expected. Contagion in the system was not hedged away as expected.

While new regulation is a given, hopefully some type of clearing house for credit derivatives and related products will also be considered to help price these assets, which will in turn will allow the markets to observe the level of risk that is currently being reflected in market prices. Regulation that encourages such transparency would be a good and necessary first step. On the other hand, if new regulation is just another way to require extra regulatory capital without really developing a mechanism for understanding the risk of the assets in question, we will once again be back where we started - not fully understanding the risk will result in companies continuing to be under-capitalized and at risk, or forced to set aside too much capital for the current levels of risk exposure. Such an outcome will simply prevent the efficient flow of capital that is necessary to spur economic growth without really addressing the problem of knowing the true levels of risk and exposure.

As reported at the Financial Times, US banks are being asked by the Federal Reserve to run a comprehensive series of stress tests to ensure they have enough liquidity to withstand various types of financial shock. The Fed regulators are asking for scenario analysis and testing to get an idea of how the banks would perform if there was a sudden and sharp downturn in the markets, or if an individual bank had to endure a major liquidity shortage, such as the one that brought down Bear Stearns. The tests are simulating mild to catastrophic disruptions, and appear to be focusing on the balances held for the various prime brokerage businesses that lend money to hedge funds. A few hedge funds have blown-up as a result of the recent credit meltdown. It is unclear if these failures were simply a warning sign of something bigger that is worrying the Fed, or just one of many areas in need of scrutiny.

While it is unknown if and how the Fed will use the specific data, the results could provide the information they need to implement new regulatory requirements if as proposed by policymakers they eventually take over some of the responsibility currently given to the SEC and other regulators. New requirements for regulatory capital are always met with mixed emotions. On the one hand, diligent and conservative risk management can provide confidence to both the markets and investors that a company can remain solvent, even in tough times. On the other hand, stricter regulation is usually followed by higher levels of regulatory capital that must be set aside, thereby reducing the banks ability to deploy its capital in the most profitable manner. The Fed and SEC recently identified the monitoring of liquidity as something they want to cooperate on with the investment banks. This current move appears to be one of the initial steps.