Financial reform seems to be going nowhere fast. Legislation has been proposed, but it is complicated and diffuse. Most of the proposed fixes are incremental changes that don’t seem likely to prevent future meltdowns or bubbles.
The House and Senate are squabbling over which federal agency should take the lead in supervising banks. The Secretary of the Treasury, as well as Congress, have fallen into the trap of trying to fix everything. Instead, they should agree on the most important remedies.
The banking crisis exposed several serious problems:
- Mortgage regulation was too lax and in some cases nonexistent.
- Capital requirements for banks were too low.
- Trading in derivatives such as credit default swaps posed giant, unseen risks.
- Credit ratings on structured securities such as collateralized-debt obligations were deeply flawed.
- Bankers were moved to take on risk by excessive pay packages.
- The government’s response to the crash also created a big hazard. Markets now expect that big banks won’t be allowed to fail, weakening the incentives of investors to discipline big banks and keep them from piling up too many risky assets again. It’s time to end too big to fail by making it less palatable for banks to remain big.
The first of these problems, mortgages, has already been addressed by the Federal Reserve and other regulators. It is much harder today to get a "ninja" loan or a mortgage with no money down. Banking regulators should ensure that the reforms stick by adding a policy principle: mortgages should be approved only on the basis of a borrower’s ability to service the loan, not on the expectation that the loan will be refinanced.
There has also been a hint of progress on the second problem - capital requirements. The Group of 20 nations have agreed to raise standards for banks when the world economy recovers. The U.S. does not need to wait we should insist on higher standards now. Leverage is already down from pre-crash levels, so regulation would ensure that banks won’t return to their old, highly leveraged ways.
The Securities and Exchange Commission and bank regulators should update model-based approaches that set leverage ratios according to Monte Carlo-type formulas. These formulas focus on too narrow a range of probabilities wherein we know that the tails, while statistically small, are significant.
The proposed legislation attacks the third issue by requiring that some derivatives be traded on an exchange where, presumably, they would receive adult supervision. Critics are unhappy because many derivatives still could be traded in customized, private arrangements.
But the issue of where derivatives are traded is secondary. AIG got into trouble because it had to post tens of billions of dollars in extra collateral as its positions went way against them. Thus, the relevant question is the amount of collateral supporting each trade.
A regulatory expert from Harvard Business School, has suggested an ingenious solution. Exchanges should require traders to post significant collateral, and the SEC should mandate that, for derivatives traded off exchanges in private transactions or elsewhere, traders adhere to the highest collateral minimums set on the exchange.
Moody’s, Standard & Poor’s and Fitch Ratings fed the mortgage bubble with crazily permissive ratings on mortgage-backed securities. The ratings companies were paid by the Wall Street firms who put the deals together and needed the ratings to market their products.
Yes this is a conflict-ridden arrangement but I believe the ratings agencies did not understand what they were rating. Chuck Prince the previous CEO of Citibank had no idea or understanding of what his derivatives desk was doing - he just let them do it (it was good for his bonus!). Also, a money management firm asked me to review a retail CDO (collateralized debt obligation) in 2008 and at first blush it looked fine, a triple A rated, 7 percent government agency bond (in a 3 percent market, hmmm). After a deeper analysis I realized this was a Wizard of Oz offering - lots of smoke and mirrors. The ratings agencies need to continuously educate their analysts to stay abreast of the new new securities coming out of Wall Street.
Inflated compensation, is endemic to all industries, not just financial firms. But it encouraged excessive risk-taking, and thus high leverage, on Wall Street (and in Charlotte). The government is trying to restrain compensation in various ways, such as rulings from the pay czar and Fed guidelines for banks. They aren’t working -- witness the return of big bonuses on Wall Street. Moreover, the new fixes suffer from micro- management. I really don’t want bureaucrats sifting through paychecks.
A better fix would be to require shareholder approval for large pay packages, say $3 million and up. Many banks would pay just under the threshold to avoid a vote. Investment bankers might discover that life can be acceptable on $2,999,999 a year. And for those who get shareholders to approve greater swag, that’s capitalism at work.
Finally, when regulators bailed out Bear Stearns, Fannie Mae and Freddie Mac, they insisted they weren’t setting a precedent for future rescues. Fed Chairman Ben Bernanke said addressing the problem of too big to fail should be a "top priority." In a perfect world, all banks would be allowed to fail.
We know from recent experience they aren’t. Endowing them with a privileged position promotes reckless behavior. The government, instead, should make it undesirable for banks to be within the circle of protection. It could do this by charging big financial institutions larger insurance premiums and by further raising their capital standard. This would encourage them to shrink to a size where failure didn’t pose a threat to the U.S. economy.
As bad as the financial crisis was, we don’t need the government running Wall Street nor do we need new federal agencies. We need a few carefully chosen rules to reassert proper incentives and proper limits. So get on it Tim, your time is running out
C Blakely 11/2009 VGKDWNUGWKGK
Sources: Bloomberg LP, WSJ, Harvard Business Review
