Financial Regulatory Reform: The Good, Bad and Ugly

In Friday’s Yahoo! Finance column, Jeremy Siegel hold forth his views on the U.S. Treasury’s recommendations to reform the U.S. financial system. Siegel's full article is here.

Referring to Treasury's release of a 89 page report titled Financial Regulatory Reform: A New Foundation, Siegel feels that Treasury’s recommendations range from the good, to the bad to the ugly.

Siegel writes:

The Good

But first, the good. The Treasury wants to establish a Financial Services Oversight Council to identify firms whose failure could pose a threat to financial stability due to their size, leverage or interconnectedness. These are called Tier 1 FHCs (Financial Holding Companies). Once the Tier 1 FHCs are identified, they would be under special regulatory supervision that involves higher capital requirements and oversight. The Council will also develop procedures to deal with these firms if they get into financial trouble.

Much of the government's actions last year seemed arbitrary, because there was no framework to take over non-bank financial firms, such as Bear Stearns, Lehman Brothers or AIG. Existing legislation deals well with the resolution of banks under the FDIC, and the government needs to develop a plan to wind down other financial intermediaries.

Some believe that no firms should be "too big to fail." But reality dictates that the government must provide some backstop for huge financial firms. Such backstops have worked for the banking industry over the past 75 years. The Treasury proposal means that if you are Tier 1 FHC then, in return for government support, you must have stricter capital, liquidity and risk management standards.

Although some argue that this gives the Tier 1 FHCs the unfair advantage of tapping the capital market with cheap debt, my hunch is that most firms would rather stay under the government's radar rather than be subject to higher capital requirements and increased scrutiny.

Siegel agrees with Treasury’s recommendation that the government should lower the safe harbor afforded by the ratings agencies, as Siegel writes:

Another good proposal would reduce the importance of the credit rating agencies, such as Moody's and Standard & Poor's. These agencies must share a good part of the blame for putting AAA labels on toxic assets.

Federal and state regulators too often allow fiduciaries to use the rating agencies as a "safe harbor" when buying assets, eliminating their own responsibility for due diligence. These safe harbors give the rating agencies far too much power and, given their poor performance in the last crisis, led many fiduciaries to take inappropriate risks. The Treasury proposal calls for reducing or eliminating references to credit ratings in many regulations.

As to Treasury’s recommendation that firms that securitize financial instruments "hold a material portion of the credit risk", Siegel disagrees:

The Bad and the Ugly

But not all in the Treasury report is good. Many proposals advocate undue interference by the government in the private sector. One bad proposal is that the government would require firms that securitize financial instruments to hold a "material portion" of the credit risk that they create. This is designed to prevent the seller from pushing bad securities into the public markets.

However, this would have done nothing to prevent the last credit crisis. In fact, Lehman, Bear Stearns and other institutions held too many of the securities that they had marketed. These firms believed they were good investments and, with short-term interest rates low, borrowed to buy more.

It is true that subprime mortgage originators took their fees upfront, notwithstanding whether the borrower defaulted or not. To link their fees to the payments by the borrower is a smart idea, but that is something that the industry can do on its own. Fees for life insurance policies are already paid in that way. There is a private incentive to get this compensation plan right, and government should not be involved.

I feel that issuers of these securities should some skin in the game. Siegel goes on to bash more of Treasury's recommendations:

Another unwarranted interference involves regulations regarding compensation for management and top executives of financial institutions. The Treasury's proposals state that regulators should issue standards to "better align executive compensation practices with long-term shareholder value," and "support legislation requiring all public companies to hold nonbinding shareholder resolutions on the compensation packages of senior executive offers."

I concede that the CEOs of these large firms were seriously delinquent in monitoring the risk of their firms' investments. And indeed part of the problem might be related to the large wealth that many were able to extract from past profits.

But getting the compensation structure right is not the job of the government. It is clearly in the interest of firms to modify pay packages so that incentives are properly aligned. Just because the crisis indicates what firms "should have done" does not mean that the government must now mandate what "must be done."

Interesting how Treasury is trying to rein in some of the Fed’s enormous powers. As Siegel writes:

Keep the Fed Independent

One proposal particularly disturbs me. The Treasury recommends amending the Federal Reserve Act to require the prior written approval of the Secretary of the Treasury for any extensions of credit by the Federal Reserve to individuals, partnerships or corporations in "unusual and exigent circumstances."

Let's not hamstring the Fed. It was the Fed's emergency loans and innovative credit programs that prevented last fall's crisis from becoming a full-fledged depression. The emergency bailout of AIG's credit default swaps, as distasteful as it was, was necessary in light of the disturbances that followed the Lehman bankruptcy. The Fed's extension of credit guarantees to the money market mutual funds was also a crucial stabilizing influence. Time was of the essence, and politics should not stand in the Fed's way.

To read the Treasury's 89 page report click here.

Disclosure: No positions.

Comments

[The Caring ...:]

Interesting article - thx for bringing it to our attention

Jul 19 08:59 AM

[Lok Sang Ho:]

It does seem that getting the compensation structure right is not the job of the government. However, if the compensation structure engenders short term behavior, even anti-social behavior, and the cost is external to the Board or Shareholders, then it does make sense for the government to ensure that incentives that compromise the social interest are not embodied in the compensation structure.

Jul 19 09:08 AM

[Barbarous R...:]

There are really only two main financial regulatory moves that need be made. First, abolish the Fed. This will eliminate the safety net behind banks, ensuring that they avoid excessive risk or they will fail. It will further prevent the government from altering the money supply, thereby eliminating future finanical bubbles.

Second, make fractional reserve lending illegal. Lending out money from demand deposits that legally belong to someone else should be viewed as fraud and treated as such. This will further prevent swings in the money supply, and eliminate the fear of bank runs. All money in the system would then be backed by savings. Interest rates would be set by the interaction between savers/lenders and borrowers, free from government agendas.

Goldman Sachs and others would no longer be able to generate tremendous profits on the back of near-free money.

There would no longer be large scale inflation or deflation, and government's power to spend recklessly would be significantly lessened. Artificial booms and busts would largely be smoothed. Prices of most manufactured products would gradually decline over time, reflecting improved technology and efficiency.

And, above all, no company in any industry whatsoever should be considered "too big to fail" and deserving of access to taxpayer money.

Jul 19 10:06 AM

[sarge 907:]

In the beginning (1913) the FED was a excellant idea and worked well until FDR politicized, albeit slightly, the agency in the 30's.

The government, both parties, has so politicized the FED over the past ten years that the symbolic term independent is laughable.

The FED must be dismantled for a democratic system to survive. For once let's let the market determine who survives and who fails, not the Federal Government.

Jul 19 10:41 AM

[Per Kurowski:]

The world is in a crisis detonated by investments in safe assets, mortgages and houses; in a safe country, the USA; and in safe instruments, rated AAA.

Any Financial Regulatory Reform that starts from the premise that what we had was “excessive risk-taking” instead of the “excessive misguided risk-aversion” that really hit the world, does not have a clue of where it is standing, and hence is most probably taking off in the wrong direction

Jul 19 11:13 AM

[crawlars:]

Agree wholeheartedly. this is one view why:

www.thenation.com/doc/...




On Jul 19 10:06 AM Barbarous Relic wrote:

> There are really only two main financial regulatory moves that need
> be made. First, abolish the Fed. This will eliminate the safety net
> behind banks, ensuring that they avoid excessive risk or they will
> fail. It will further prevent the government from altering the money
> supply, thereby eliminating future finanical bubbles.
>
> Second, make fractional reserve lending illegal. Lending out money
> from demand deposits that legally belong to someone else should be
> viewed as fraud and treated as such. This will further prevent swings
> in the money supply, and eliminate the fear of bank runs. All money
> in the system would then be backed by savings. Interest rates would
> be set by the interaction between savers/lenders and borrowers, free
> from government agendas.
>
> Goldman Sachs and others would no longer be able to generate tremendous
> profits on the back of near-free money.
>
> There would no longer be large scale inflation or deflation, and
> government's power to spend recklessly would be significantly lessened.
> Artificial booms and busts would largely be smoothed. Prices of most
> manufactured products would gradually decline over time, reflecting
> improved technology and efficiency.
>
> And, above all, no company in any industry whatsoever should be considered
> "too big to fail" and deserving of access to taxpayer money.

Jul 19 12:48 PM

[denko:]

<i>Another good proposal would reduce the importance of the credit rating agencies, such as Moody's and Standard & Poor's. These agencies must share a good part of the blame for putting AAA labels on toxic assets.

Federal and state regulators too often allow fiduciaries to use the rating agencies as a "safe harbor" when buying assets, eliminating their own responsibility for due diligence. These safe harbors give the rating agencies far too much power and, given their poor performance in the last crisis, led many fiduciaries to take inappropriate risks. The Treasury proposal calls for reducing or eliminating references to credit ratings in many regulations...</i>

Living4dividends ... thanks for the good post. & sure ...

There should never have been, and probably is still no need, for ratings agencies to be regulated.

For too long financial institutions, seeking to accumulate quality asset backed securities, deemed themselves aloof of normal trade practices in their mutli-million $ deals.

The most humble yet savvy roast chestnut or barrow merchant would apply and endorse a greater due diligence when acquiring his daily bag of nuts/stock in trade than some of the world's greatest (err vainglorious) purchasers of CDOs.

Purchasers simply abandoned the principal of 'caveat emptor' - and their reliance on the rating agencies seal of approval - PAID FOR BY THE SELLOR - has led to a predictable outcome.

Did BUYERS ever think to get their own ratings agencies assessment? Clearly - never!

If only they'd sought the barrow merchants advice - 'thinks like joe for jellied!'
(joe rook - the crook) (jellied eels - deals)

i.e. always - think like a criminal - and only ever trade at 'face' value - Buy with a long face; Sell with a straight face; (and err... Hold with a two face¿)

fwiw

...but 'they' know all this!

Jul 19 10:09 PM

[Living4Divi...:]

You're welcome, Denko


On Jul 19 10:09 PM denko wrote:

>
> Living4dividends ... thanks for the good post. &amp; sure ... <br/>
>
> There should never have been, and probably is still no need, for
> ratings agencies to be regulated.
>
> For too long financial institutions, seeking to accumulate quality
> asset backed securities, deemed themselves aloof of normal trade
> practices in their mutli-million $ deals.
>
> The most humble yet savvy roast chestnut or barrow merchant would
> apply and endorse a greater due diligence when acquiring his daily
> bag of nuts/stock in trade than some of the world's greatest (err
> vainglorious) purchasers of CDOs.
>
> Purchasers simply abandoned the principal of 'caveat emptor' - and
> their reliance on the rating agencies seal of approval - PAID FOR
> BY THE SELLOR - has led to a predictable outcome.
>
> Did BUYERS ever think to get their own ratings agencies assessment?
> Clearly - never!
>
> If only they'd sought the barrow merchants advice - 'thinks like
> joe for jellied!'
> (joe rook - the crook) (jellied eels - deals)
>
> i.e. always - think like a criminal - and only ever trade at 'face'
> value - Buy with a long face; Sell with a straight face; (and err...
> Hold with a two face¿)
>
> fwiw
>
> ...but 'they' know all this!

Jul 20 07:21 AM

[Jeremy Dreman:]

I dont know wha tthe heck this has to do with investments - but it was a pretty good article - thank you.

Jul 22 02:43 PM

[Living4Divi...:]

Professor Ho - I agree with you 100% on this. The government could set general guidelines and policies that mandate that Bank Officers get compensated for the profits that they make as a proportion of the risk that they take. A Sharpe Ratio Based compensation scheme. More important, somehow the Bank Officers have to have skin in the game. If they run the bank into the ground, they lose. Perhaps 25% of their retirement savings shall be in non-transferable bank stock or some sort of phantom stock. When it's their nest egg on the line - then I'm sure that Bankers will start acting like bankers of old.

On Jul 19 09:08 AM Lok Sang Ho wrote:

> It does seem that getting the compensation structure right is not
> the job of the government. However, if the compensation structure
> engenders short term behavior, even anti-social behavior, and the
> cost is external to the Board or Shareholders, then it does make
> sense for the government to ensure that incentives that compromise
> the social interest are not embodied in the compensation structure.

Jul 22 07:03 PM