US Economy: Financial Group Suggests Reforms for Banking Industry

A panel of top Wall Street bankers has recommended cigarette-style health warnings on complex financial instruments and has suggested that ill-considered bonus packages may be encouraging financiers to take excessive risks.

In a 176-page report on the credit crunch, an industry-wide group of senior financial executives has called for a raft of changes to disclosure, governance and stress testing at banks, together with restrictions on the sale of certain potentially toxic derivatives.

Chaired by a Goldman Sachs managing director, Gerald Corrigan, the group blames age-old human foibles for the global financial crisis – but adds that distorted pay structures may have contributed by encouraging gung-ho behavior.

"The root cause of financial market excesses on both the upside and the downside of the cycle is collective human behavior – unbridled optimism on the upside and fear – bordering on panic – on the downside," it says.

While avoiding criticism of the sheer size of City and Wall Street bonuses, the panel criticizes the way pay packages are put together, saying that incentives have "inadvertently produced patterns of behavior and allocations of resources" that are not always consistent with "the basic goal of financial stability".

Called the counter party risk management policy group, the panel's members include representatives from HSBC, Citigroup, Lehman Brothers, Morgan Stanley, BNP Paribas and Merrill Lynch.

In a striking recommendation, they say that complex instruments should only be sold to carefully vetted, sophisticated clients which have the wherewithal to withstand heavy losses and to analyze the risks involved.

These investments, say the panel, should come with an extensive term sheet setting out all their characteristics. This sheet should have a "financial health warning" displayed in bold print which alerts investors to the risk of "significant loss".

Elsewhere, the bankers call for regular meetings between regulators and the boards of directors of financial institutions. They suggest improved stress testing by banks, brainstorming to identify risky "hot spots" and frank disclosure of assets held off banks' balance sheets – using a "holistic and principles-based approach".

The findings are to be sent to the US treasury secretary, Henry Paulson, and to Mario Draghi, the governor of Italy's central bank who chairs the international financial stability forum.

Since it began with a meltdown in the sub-prime mortgage market a year ago, the credit crunch has led to the collapse of America's fifth largest investment bank, Bear Stearns, and troubles at high-street banks around the world including Britain's Northern Rock and California's IndyMac Bancorp.

Many argue that the banking crisis has been aggravated by "creativity" within institutions in coming up with increasingly esoteric financial products – including collateralised debt obligations, auction-rate securities and credit default swaps.

The panel said write-offs taken by banks in the US and Europe are of "staggering proportions" and that firms were troublingly slow to realize the magnitude of the crisis, lulled into a false sense of security by earlier disturbances which quickly resolved themselves.

"It is probably fair to say that, as late as the summer of 2007, virtually none of us would have imagined that, as of July 2008, financial sector write-offs and loss provisions would approach $500bn, even as the write-off meter is still running," say the bankers.