Economics PAN Information Resources: Topic - Background on the Economic Crisis and Key Policy Debates
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Background on the Economic Crisis and Key Policy Debates
In 2006, Nouriel Roubini, economist at New York University’s business school, made a presentation at the IMF in which he predicted that the US would soon be facing an economic downturn comparable to the Great Depression of the 1930s. He argued that the crisis would be precipitated by a collapse in the housing market, since the bubble in housing prices had been unwisely fuelled by cheap credit, lax lending standards, and the unrestrained growth and complexity of the mortgage-backed securities market. While Roubini’s warnings were not heeded in 2006, his foresight distinguished him and gave him membership in a very small club of economists, financial professionals and policymakers who saw the crisis coming.
Nouriel Roubini Prediction 2006 at IMF meeting. Report in The New York Times.
The Senators and Economists Who Called it Right. Article in The Huffington Post.
Who’s to Blame for the Crisis: Bankers or Economists? Article in Slate.
The Failings of Economists. Article in Business Week.
So, what caused the current crisis and why did so few see it coming?
If past crises are any indication, this question will be debated for years and possibly decades to come. The current narrative on the 2008/2009 crisis seems to apportion some blame at each level –
prospective homeowners stretched to take on too much debt;
mortgage brokers encouraged clients to take on loans that turned out to be too risky, and, in the extreme, some mortgage brokers falsified income and asset data to get loans approved;
investment banks purchased these loans in bulk from the mortgage brokers with little regard for their quality, since they were simply going to package and sell them to institutional investors;
rating agencies found a way to give the highest credit ratings to pools of some of the weakest credits, believing that geographic diversity would offer investors an appropriate measure of protection;
investors were pleased to earn outsized returns on seemingly low-risk, AAA-rated mortgage-backed securities and demanded that investment banks package more of them;
insurance companies, like AIG, were earning healthy premiums for providing investors with protection against possible defaults on these mortgage-backed securities;
banking and securities regulators appeared unable or equipped to protect consumers and the wider taxpaying public from a potential collapse of the entire banking system; and, finally,
politicians on both sides of the aisle were keen to see increased levels of home ownership while enjoying the benefits that accrued from an ever-expanding economy.
This narrative views the crisis as a “perfect storm” insofar as the protections which should have been in place at each level failed, leaving the problems to escalate to the point where they became an existential threat to the global financial system. Why was this the case? Because, at every point in the process, individuals were getting exactly what they wanted – bigger houses, more revenues, better bonuses, more votes, etc. Therefore, the handful of people who voiced objections were easily sidelined and marginalized.
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Michael Lewis Article on the Origins of the Crisis: The End.
Lewis/Einhorn Article on the Origins of the Crisis
Paul Krugman Article on the Origins of the Crisis
Ben Bernanke: How We Got Here
As time progresses, more information will become available to help us understand why such failures occurred at so many levels. For instance, if the Fed under Alan Greenspan had simply agreed to regulate mortgage brokers (when asked to do so by various states), the worst excesses might have been prevented. Similarly, if the ratings agencies had refused to give these securities “AAA” ratings, the market would never have grown so large. And, if the SEC had not agreed to relax the net capital rules governing investment banks (lobbied for by Goldman Sachs’ leader at the time, Hank Paulson), these banks would have not been left in such a fragile funding position when the credit markets seized up. To achieve better clarity on the causes of the crisis, there are those who have called for a series of hearings, similar to those run by Ferdinand Pecora, during the Great Depression. Such hearings would require the participation of all players - from mortgage brokers to investment bankers, and ratings agencies to regulators - in a fact-finding mission. The goal would be to ensure that the right policies are enacted today so that these types of abuses are prevented from occurring again. President Obama agreed to set up such an investigative panel in May 2009.
Pecora Hearings Redux
Obama Agrees to Establish Investigative Panel on Origins of the Financial Crisis
Mortgage Brokers and Rating Agencies
The role of mortgage brokers and the rating agencies often does not get the attention it deserves in the press, since much of the space is devoted to investment bankers and their outsized pay packages. However, these two actors played critical roles in creating both the supply of (and the demand for) mortgage-backed securities. As such, their activities deserve more attention.
While some mortgage brokers were honestly trying to get the best deal for their clients, many more were seeking the highest fees for themselves. This was accomplished principally by favouring volume over quality. The anecdotal stories of abusive practices reveal mortgage brokers talking elderly homeowners into refinancings that would eventually explode in cost, pushing many out of their homes or back into the workforce post-retirement. Income and asset verification fell by the wayside and “NINJA” loans (to people with “no income, no job or assets”) were routinely granted. Even those with good credit histories were duped into paying more for their mortgages than necessary, simply because their broker wanted to earn a higher fee. Hundreds of ongoing investigations will reveal more about the methods used by mortgage brokers, methods which increased the severity of the crisis by increasing the volume of vulnerable homeowners across the country.
Predatory Mortgage Lenders – How They Were Paid
The Role of the Shadow Banking System in the Crisis
CEO of Countrywide Accused of Fraud by SEC
The rating agencies – Moody’s, Standard and Poor’s and Fitch – acted largely as “enablers” in this process. After all, the investment banks were keen to sell their mortgage-backed securities to investors, but they had to first convince the rating agencies that these securities were sound. The rating agencies have a special role in the financial system insofar as they are an oligopolistic group charged with offering investors their best, objective estimate of the likelihood of default of a debt security. The better the rating (the best being AAA/Aaa), the lower the likelihood of default. However, the relationship between the investment banks and the rating agencies has long been rife with conflicts. The most glaring conflict is that the agencies are paid by the issuers of securities (in many cases, the investment banks) and not the buyers of securities (in this case, the end investors). And, with complex, mortgage-backed securities, the agencies earned four times more than they did on rating straightforward, vanilla bonds. The agencies strongly deny that they altered their quantitative methods for financial gain, but it is hard to square the AAA-rating on more than 63,000 issues of mortgage-backed securities when only 12 companies enjoyed that rare distinction in 2007. Also, for those who are more quantitatively oriented, it appears that the use of a formulaic short-cut on correlation (the Gaussian-Copula formula) helped to boost ratings of mortgage-backed securities, a simplification that would later have dire consequences. How these changes were incorporated into the mathematical models needs further explanation. It is important to point out that the rating agencies have not traditionally been subject to legal liability for mistaken ratings, since they claim their ratings to be “opinions” and have argued (and won) protection in previous cases under the First Amendment. It will be interesting to see this defence tested once more, since new lawsuits have been filed relating to their ratings on Lehman bonds and the firm’s subsequent bankruptcy.
Rating Agency Failures
Gaussian Copola Formula: Article on correlation
Rating Agencies Inquiry Opened
Mary Shapiro, SEC Chair, on Rating Agency Regulation (and Legal Liability)
First Law Suit Filed Against Rating Agencies (on Lehman bankruptcy)
The (Almost) Failure of AIG
How did a company that began its life as a traditional insurer, underwriting such utility products as life, property and casualty insurance, end up as a potential risk to the US and global financial system? In part, it is because AIG strayed quite far from its roots, setting up a 400-person financial products group in the late 1990s whose mission was to expand the firm’s participation in the new and lucrative field of credit default swaps (CDS). A credit default swap is essentially a contract in which the seller/writer of the swap (in this case, AIG) agrees, in return for an annual fee, to make the swap purchaser whole if the debt security he is holding defaults. In other words, if an investor had purchased a CDS from AIG on Lehman bonds, once Lehman declared bankruptcy and defaulted on its bonds, that investor could go directly to AIG (which enjoyed a AAA bond rating) and ask to be paid in full. At its peak, AIG had close to $2.6 trillion of outstanding credit default swap obligations. And, while the Lehman bankruptcy was a trigger for public panic over AIG’s ability to meet its CDS obligations, in fact, AIG had even greater obligations insuring mortgage-backed CDOs. (Many of these contracts were purchased by the large commercial banks, both domestically and internationally, as well as investment banks and hedge funds.) So, after Lehman’s failure on September 15, 2008, the Fed and US Treasury stepped in to support AIG’s obligations, since it was viewed as “too interconnected to fail.” Later, it became apparent that large sums were owed by AIG under CDS contracts to US financial firms like Goldman Sachs and JP Morgan, as well as to British, French and Swiss banks. Had AIG gone under, it would have created even larger financial reverberations than the Lehman failure.
In light of AIG’s large and undetected CDS exposure, there is now a rallying cry for material reform in the area of CDS and derivatives more broadly. One idea is to require all derivative contracts to be traded on an exchange or through a clearinghouse. This would provide transparency to regulators – so they would know the total volume of contracts outstanding at any one time – and would also enable regulators to control collateral requirements thereby reducing the potential fragility of the market. Because AIG had a AAA-rating, many of its counterparties didn’t require the insurer to post collateral for any potential future obligations that AIG might have to them. It wasn’t until AIG’s weaknesses became apparent to the market that many of its counterparties (like Goldman and JP Morgan) moved in and demanded collateral. This move made it clear just how much of a hole AIG had in its balance sheet and prompted regulators to take control of the insurer on an emergency basis shortly after the Lehman failure. The Fed and Treasury were both frustrated and angered not to have been forewarned about the severity of AIG’s problems.
Another possible reform to avert this type of collapse is to require that anyone purchasing a CDS actually own the underlying bond. In the absence of this limitation, the volume of CDS’ grew to a size that dwarfed the debt market itself. This is because many traders were holding “naked CDS positions”, essentially engaged in a purely speculative bet on whether a particular security would default.
Eric Dinallo, NYS Insurance Commissioner, on Reining in Credit Default Swaps
After AIG was stabilized, a good deal of criticism was directed at the response of Treasury, since it enabled a number of banks to benefit indirectly from government largesse. Goldman Sachs, for example, received close to $13 billion in payouts under contracts with AIG, funds it would not have received if AIG had been allowed to fail. JP Morgan was not far behind. The Treasury defends its position on the basis that in the midst of a crisis, you cannot discriminate among counterparties, and the actions were necessary to stabilize an already panicked system in the wake of Lehman’s failure. Others maintained that the Treasury should have paid out less than 100 cents on the dollar so that taxpayers could have gotten a better deal.
Spitzer Focuses on the AIG Counterparty Deals
Did AIG Need to Pay its Counterparties 100 cents on dollar?
AIG Counterparty Payments Revealed
The Role of Banks and Banking Compensation in the Crisis
One clear failure in this crisis was the way in which the bonus and incentive systems of banks encouraged certain bank employees - especially those engaged in sales and trading - to take on risks that were ultimately detrimental to the long-term interests of shareholders. While this seems counterintuitive - since star bankers were paid in both stock and cash - in fact, the cash portion of their compensation was often high enough (and dispensed quickly enough) for that banker to care less about the stock price and the long term performance of his or her institution. Ironically, the firms with the highest percentage of employee-owned shares - Bear Stearns and Lehman Brothers – were also the two banks to meet the most disastrous ends, pointing up just how poor the compensation system was in aligning employee and shareholder interests.
In order to remedy the perversion of the old incentive system, many banks have revised their pay packages to include more stock. This stock is now held in deferment and paid over longer periods (between three and five years). Some banks have even instituted claw-back provisions so that previously earned (but deferred) bonuses could be forfeited if the bank (or a division) loses money in a year. These changes should better align the interests of employees and shareholders and produce more favourable, long-term results for both.
As soon as the Treasury called for general reforms to pay practices, Wall Street responded by being both proactive and specific, so as to avoid having these changes mandated from Washington. However, we have already seen some proposals from Treasury (see below) that establish guidelines on executive pay for institutions that have taken taxpayer money (as well as for those that have not).
Geithner Proposes Overhaul of Wall Street Pay Practices
Goldman Sachs’ Lloyd Blankfein “apologizes” for Wall Street Behaviour and Calls for Changes to Pay Practices
The Failure of Risk Management
Regardless of the compensation incentives that pushed mortgage origination teams and traders to take more risk onto the balance sheet of banks, one can legitimately ask: Weren’t the risk managers supposed to protect against this type of behaviour? If so, where were they? After all, their role was to constrain risk on the downside for the shareholders and protect the bank from large and disastrous losses.
The problem was that risk managers had become overly reliant on complex “value at risk (VAR)” and “stress” models. These models evolved to the point that they claimed to be able to quantify, to the dollar, the amount of potential capital at risk over a one to ten day period at very high confidence levels (95% - 99%). One problem with the level of specificity generated by these models is that they didn’t invite enough questioning. Senior bank management became too reliant on them and too complacent that they were simply calculating the “right” answers. Furthermore, it is entirely possible that the increasing complexity of these models left too many in senior management (and in the boardroom) unequipped to challenge them.
The other problem had to do with how the models were constructed. Since future potential losses were all derived from historical data, it seems that the models never went back far enough to capture data from periods where we experienced truly global banking panics, liquidity crunches and a nationwide housing slump. That’s because capturing such events would have required going back 60 or 70 years, to the Great Depression, an event that was thought to be so singular that it could not repeat itself. Therefore, the 95%-99% “confidence levels” didn’t account for a low probability (but high impact) event, like the Great Depression, that could threaten a bank’s very survival as well as the survival of the financial system. And, that is what the sub-prime crisis of 2007-2008 turned out to be – a low probability but high impact event.
In his books Fooled by Randomness and The Black Swan, Nassim Taleb criticizes the industry-wide dependence on VAR and stress models to manage risk. Many have likened these models to air bags in a car that work well except when you are in an accident. Clearly, then, reforming risk management practices is a high priority going forward. And, even if models will always be inherently limiting, the role of a bank’s senior management should be to consistently question them and take steps to ensure that concentrated risks aren’t endangering performance, regardless of what a model might say. Ironically, banks started to hold AAA-rated mortgage securities in increasing amounts in the years leading up to the crisis to generate higher returns on their capital. And, these securities never sounded the “VAR alarm” because they were lumped together for analytical purposes with other super-safe, AAA-rated debt instruments (or supposedly hedged). While a few banks, like Goldman and JP Morgan, understood the weaknesses in the models and took evasive and protective action when the sub-prime crisis unfolded in 2007, much of the industry did not. If this episode teaches us anything, it is that a bank’s management team must be constantly vigilant, never forgetting that the power of the market can reduce any quantitative model to rubble and take the bank’s capital with it.
Does “To Big to Fail” Equal “Too Big to Exist”?
Aside from the questions of banker compensation and risk management failures, there is the larger question of what our financial system should look like going forward. The financial conglomerates that have emerged since the 1980s (Citi, JP Morgan, BofA, etc) were not so much a natural evolution as a hard fought effort by the bank lobbies to have Depression-era regulations overturned. In 1999, the Glass-Steagall Act, which had required the separation of investment and commercial banks during the Great Depression, was officially repealed. However, this repeal was more of a formality since the banks had been successfully chipping away at Glass-Steagall for the previous ten to fifteen years.
There is one school of thought in the current crisis which calls for breaking up the big banks, echoing the “trust-busting” efforts of Theodore Roosevelt with the railroad and oil company monopolies in the early 1900s. The argument is that any bank that is too big to fail, should not exist. This is because the top ten to twenty banks in the US operate as if they have an implicit government guarantee. They enjoy low funding costs and attract depositors and clients, and when times are good, they share the profits generously with employees and shareholders. However, when a crisis hits, they hold the “systemic risk” gun to the head of their own government, forcing that government to come to their rescue. It has happened time and again, and some believe that the only solution is to ensure that each bank is small enough so as not to create systemic risk if it fails. They believe that this would instill better discipline in bank CEO’s and employees, since they would no longer enjoy the comfort of an implicit government backstop. It would also prevent taxpayers from being held hostage by their largest banks.
An alternative to breaking up large banks is simply to make it harder and more expensive to be a large bank. In other words, these firms can be told to expect tighter supervision and closer scrutiny from regulators as well as higher capital requirements, all of which would increase the costs of being a “systemically important” bank. Under that scenario, banks can either voluntarily decide to divest of certain operations, thereby becoming less systemically important, or they can agree to submit to a tighter regulatory net. Either way, taxpayers would win and financial stability would be improved.
Simon Johnson, an MIT economist, goes further and compares the political power enjoyed by bankers and their lobbying arms to “oligarchs in a banana republic.” Their contributions to political campaigns (often evenly split between Democratic and Republican candidates) ensure them not only access, but a powerful voice in shaping policy and regulation. Curbing this influence would clearly require a wholesale change to the American political and electoral system and have implications far beyond banking. After all, outsized influence is also enjoyed by other industry groups – pharmaceutical manufacturers, oil companies and defence contractors are just a few that spring to mind.
Finally, there are those who argue that the banks should simply be nationalized. Rather than throwing taxpayer money into a bottomless pit, they maintain that taxpayers should purchase the banks outright, control bankers’ compensation, and offer loans to businesses that need them most. This strand of argument has faded as many banks reported record first quarter 2009 profits, and a number of large TARP recipients have informed the Treasury that they want to repay the taxpayer loans that were made late in 2008. This should be welcome news, and a sign that many banks have weathered the worst of the economic storm. For those who still favour nationalization, the truth is that the Treasury always retains the power to take over a bank (witness its strategy with General Motors and the fact that it now owns approximately 34% of Citibank). Rather, this tool is viewed as a last resort, and while we may see a bank nationalization in the future, all other tools in the Treasury’s arsenal are likely to be exhausted first.
Elliot Spitzer’s “too big to fail” article
Simon Johnson (MIT) on Breaking up the Banks
Simon Johnson (MIT) says US is a “banana republic” with the political process dominated by outsized influence of Wall Street contributions
TARP Oversight Board Recommends Bank Nationalization
Geithner’s Public Private Investment Plan (PPIP): Pros and Cons
As part of his effort to promote financial stability, Treasury Secretary Geithner has proposed a Public-Private Investment Partnership to remove the remaining toxic assets from bank balance sheets. When it was first announced in broad terms, the markets responded favourably; however, as time has progressed, the reviews have become largely mixed. There is broad support from the investment management community, especially from those who would be likely purchasers of the toxic assets. Both Larry Fink from Blackrock and Bill Gross from Pimco praised the plan. Nouriel Roubini, the NYU economist, had more of a neutral response, saying that the plan had merits, but the big problem would be getting the banks to sell these assets at a loss, since no one would buy them at current book values. With banks frantically trying to preserve and/or bolster their capital levels, selling toxic assets at a loss would only frustrate that objective. Finally, there was a good deal of antagonism to the plan voiced by respected economists, including Jeffrey Sachs and Nobel-prize winners, Paul Krugman and Joseph Stiglitz. Their view was that the PPIP put taxpayers at too much risk, and once again, enabled private investors to gain at taxpayers’ expense.
How does the PPIP work? Say that a bank has a mortgage-backed CDO valued on its books for $100. An approved investor, like Pimco, could come along, independently assess that CDO, and offer to pay the bank $70 for it. Assuming the bank accepts, Pimco would put down $5 of its own capital as equity. The Treasury would then put down the other $5 in equity (for a total of $10 in equity), and the government would provide a guarantee for $60 in long term, non-recourse, low interest-rate debt. The Treasury maintains that the taxpayer gets the benefit of “piggybacking” the pricing expertise of Pimco and other professional investors, thereby reducing the risk of incorrectly valuing these securities. And, if the plan works as anticipated, the taxpayer stands to get 50% of the upside on the equity portion. However, as Sachs and others argue, the taxpayer is essentially making a $60 non-recourse loan to Pimco. This means that if the investment goes bad, then Pimco is not on the hook to pay back the loan. The taxpayer eats the loss totalling $65 of the $70 initial investment. The private investor only loses $5. So, the economics of this investment are quite attractive to the investing community, which explains their widespread support in light of the withering criticism levied by economists. Secretary Geithner will expand on the details of this program in June 2009.
Jeffrey Sachs on PPIP
Stigliz on PPIP
Krugman on PPIP
Stiglitz's Critique of Administration’s Bank Proposals
Game Theory Points to PPIP as Fraudulent
Roubini on PPIP (backs it as one piece of overall policy plan; keeps nationalization on the table)
Pimco’s Bill Gross Positive on PPIP
Blackrock’s Larry Fink Positive on PPIP
Financial Regulatory Reform: A New Foundation
On June 17, 2009, the Obama administration announced a new plan for financial regulatory reform, one that focused principally on eliminating the weaknesses and failures that led to the crisis of 2008. Some of the key features of the proposal are summarized below:
The Federal Reserve is charged with acting as the systemic risk regulator, giving it special authority to regulate any financial holding company (either a Tier 1 Financial Holding Company or Bank Holding Company) that is deemed to be too large, leveraged or interconnected to fail without negatively impacting financial stability. The plan also gives the Fed special “resolution” powers should any Tier 1 Financial Holding Company or Bank Holding Company become distressed. Therefore, rather than face the impossible choice between disruptive bankruptcy or taxpayer bailout, the new powers would allow the Fed to place a troubled firm into conservatorship/receivership for a more rational and orderly workout process.
“Systemically important firms” will be identified by a new Financial Services Oversight Council, consisting of the Treasury Secretary, Federal Reserve Chairman, Head of the National Bank Supervisor, the Chairpersons of the SEC, FDIC and CFTC, etc. At the moment, there are no specific criteria to identify these firms, but one would expect the top commercial/investment banks, brokerage firms, insurance companies and hedge funds to be captured by the definition.
Systemically important firms can also expect to face tougher capital and liquidity requirements than their smaller competitors, as well as the need to implement more stringent risk control standards. While the new proposals do not forcibly break up large firms - like <?xml:namespace prefix = st2 /><?xml:namespace prefix = st1 />Franklin Roosevelt did with Glass-Steagall in 1933 - it does make it more costly to be big. Therefore, a financial firm’s “optimal” size may change over time as a result of these new regulations.
The Office of Thrift Supervision will be merged with the Office of the Comptroller of the Currency in the Treasury Department, creating a single, new National Bank Supervisor. The hope is to eliminate regulatory arbitrage for banks at the national level.
To enable consumers to better understand the risks they are taking when they purchase financial products like mortgages, student loans and credit cards, the plan calls for the establishment of a new Consumer Financial Protection Agency (CFPA). The agency will ensure that all consumer financial contracts are easily understandable and comparable; additionally, the CFPA will be empowered to levy fines for non-compliance and predatory practices.
Finally, the reforms include a requirement for all standardized OTC derivatives to be cleared through regulated central counterparties. Where this is not possible, audit trails and tougher dealer regulation will fill the oversight gap. Had this regulation been in effect in 2008, it would have eliminated the ability of AIG to accumulate significant and undetected credit default swap exposure on its balance sheet, leading to its near failure. The administration’s goal with derivatives reform is to make the market more transparent, while giving regulators the ability to monitor collateral, establish position limits and prevent market abuse.
Geithner and Summers Op-Ed on New Financial Regulatory Framework (June 16 2009)
White Paper on Financial Regulatory Reform
Final Treasury Proposal on Financial Regulatory Reform
OTC Derivatives Regulation: Proposals from SEC and CFTC
Economist on Reform Plan: Bold and Timid
Bloomberg: Reform Proposal is a Band-Aid
WSJ: Historic and Sweeping Financial Reform
Treasury Proposals to Reform Banker Compensation
One of the most contentious aspects of this financial crisis has been the level of compensation paid to bankers and the excessive risk-taking it encouraged. Reform to banking pay was announced before the regulatory overhaul plan and dealt specifically with pay practices at firms receiving “exceptional taxpayer assistance” while providing general guidance on compensation to non-TARP firms as well.
For taxpayer funded firms, a Special Master of Compensation (or Pay Czar) was designated with the ability to review, reject and even set pay levels (with no appeal) for all senior executives and the top 100 earners. For other firms, the administration called for shareholder votes on executive compensation (the “say on pay” votes) which, although they are non-binding, provide some degree of moral suasion. There was also a call for more independence on the part of compensation committees, especially from the executive members of the board. Although we are relying on non-TARP firms to make changes that are largely voluntary, a number of the big banks have already started awarding bonuses in stock and deferring them long enough to allow for clawbacks in the event of future losses.
Obama Seeks to Give SEC Oversight on Executive Compensation
Obama “Say on Pay” Initiative for Executive Compensation/Appointment of Special Master with Power Over Compensation Plans at Companies Taking Govt. Money
Treasury “Master” To Set Pay at Ailing Banks
Now that these proposals have been announced, there will be considerable bargaining between the actors - the administration, Congress, the regulators and bank lobbyists - before a new regime is created. The events over the past two years clearly demonstrate that a new framework is necessary to protect the financial architecture, which is vital to the proper functioning of any economy. Post-depression regulation served us well for the half-century leading up to the crisis. The stakes are equally high and the burden comparably great to put in place new rules that protect consumers, taxpayers, investors and the system as a whole. While special interests will seek concessions, the hope is for an enlightened debate that leads to a sensible and long-lasting financial regulatory regime.
Authored by Dr Deirdre Shay Kamlani, June 2009