The Rubin-Greenspan legacy: now Paulson's ongoing nightmare.

• Author: Whalen, Christopher

Few Secretaries of the Treasury have encountered the firestorm of crises and events that have confronted U.S. Secretary of the Treasury Henry Paulson. The former CEO of Goldman Sachs certainly did not cause the financial crisis of 2008--at least not during his tenure at Treasury--but his actions and failure to act will leave a profound impression on the financial markets for decades to come. The nationalization of a good chunk of the U.S. banking industry and a vast cleanup still to be accomplished are Paulson's legacies to the next president.

Such is the magnitude of the financial and economic crisis facing the United States and other global economies that the particular actions of political officials such as Paulson and Federal Reserve Chairman Ben Bernanke seem almost irrelevant. Indeed, both Paulson and Bernanke have the unenviable task of cleaning up the mess left by their respective predecessors, who are under growing attack for their policy decisions. A cursory inventory of the major issues facing the industrial nations in terms of banking regulation and financial market structure tells the tale:

Basel II. The just-adopted Basel II capital adequacy framework lies in tatters. Under the Treasury's bailout program for the banking sector, for example, banks can get capital infusions from 1 percent to 3 percent of risk-weighted assets. But since the so-called regulators have proven that they don't know how to risk-weight assets, because they're using models based on the same so-called financial methods as those of the banks and the so-called rating agencies, the entire Basel II framework has lost all credibility with investors.

As regulators in the G7 nations ponder a "Basel III" capital adequacy framework, hopefully they will consider whether "risk management" in a global sense is really possible, especially as envisioned in the Bank for International Settlements approach to Basel II. Using flawed concepts such as "value at risk or "VaR" to drive a regulatory measure of capital adequacy is silly, yet it is now in the law and regulation in the European Union and will take effect in the United States in January. The more this writer works with risk and analytics professionals, the more I appreciate that the image of rational direction of large enterprises is more hope than reality. Thus, our firm focuses on using verifiable data and classical metrics for rating U.S. banks rather than discredited methods such as those embraced in Basel II.

Whether you are an investor, regulator, or ratings agency, the disruption of the consensus around price and valuation, and therefore the solvency of counterparties, is creating instability, but that process of reformulating pricing methods requires time and focus. And the debate over the new framework for relating price to value (or risk) is only beginning. On October 21, 2008, former Citigroup Chairman John Reed commented in a letter in the Financial Times that, going back a decade or more, two misjudgments where made:

"The first was to assume that markets could better manage and absorb risk than institutions. Most of us believe that markets are the best at allocating capital ... Our second error was to embrace the notion of risk-adjusted capital, saying, in essence, that we know where the risks are. This too was...