How to Reform the Financial System: Our 10 Point Proposal

Includes: BAC, GS, JPM, KBE, MS, WFC, XLF
by: Tom Brown

After I described President Obama’s financial regulatory reform proposals as “asinine here last week, readers squawked that I wasn’t being constructive. “So is your only mission raising counterpoints?” one wanted to know, “or do you have a better set of ideas?”

Actually, I do! Few people argue the country’s financial regulatory structure doesn’t need to be fixed. It was built to cope with a 1930s banking world that became obsolete decades ago. But what do we replace the old regime with? Not a passel of new restrictions on trading or taxes on bank liabilities. Instead, here’s what needs to be done:

1. Consolidate bank regulatory agencies. The current regulatory setup is basically a six-pack of alphabet soup. There’s the FDIC, which regulates all banks that obtain FDIC deposit insurance. And the OCC, which oversees some nationally chartered banks. The OTS monitors national thrifts, while the Fed regulates bank holding companies and some nationally chartered banks. Throw into the mix the various state banking regulators, which handle all state chartered institutions.

It all adds up to a patchwork of regulation that’s costly and only spottily effective. Regulators work at cross purposes from each other and spend more time protecting their turf than providing thoughtful regulation. (Chief culprit in this regard: Sheila Bair). Banks shop regulators, and play one off against the other. Bankers spend more time dealing with regulators and less dealing with customers and employees.

To this, the President now wants to add a Consumer Financial Protection Agency and a “resolution authority”? Please. Instead, the government should do the following: a) eliminate the thrift charter and the OTS, b) combine the supervisory responsibilities of the Fed, the OCC, and the FDIC into a single banking regulator, and c) deny FDIC insurance to non-nationally chartered banks.

The resulting single bank regulator would of course have many responsibilities; the two most important would be supervision of products and ensuring the safety and soundness of institutions.

Combining regulatory agencies would create both efficiency and regulatory consistency. Plus, banks would no longer be able to push back with the threat of charter switching.

2. Regulate institutions as if “too big to fail” didn’t exist. It’s easy to forget the enormous power regulators have over banks. They can force banks to sign memorandums of understanding that mandate major changes in practices. They can unilaterally issue cease-and-desist orders to prohibit unsound practices. They even have the power to declare an institution insolvent.

As I say, regulators swing a big bat. They should get in the habit of using it—but not just in a downcycle, when a crisis has already begun. Instead, regulators have to be more proactive with their powers during the good times. That’s when risks related to issues such as, say, loan concentrations and funding can be addressed. The bank regulator should be able to handle the failure of any size institution by breaking up any institution into its healthy parts and its unhealthy parts.

By contrast, proposals floating around lately for ways to deal with troubled institutions in the future are doomed. “Living wills,” for instance, won’t work because no can know in advance the particular circumstances that might cause a large institution to run into trouble. “Contingent capital,” meanwhile is just as expensive as the real thing. And as we see with Lehman, no matter how much you have at crunch time, it won’t be enough.

The key to ensuring the system’s strength is to make sure that every institution that operates in it is subject to the discipline of the market. That means that in the event of failure, shareholders and unsecured creditors must be wiped out. In reality, we’re of course stuck with too-big-too-fail: no one can say what catastrophic events might happen that would force the government to act. But that doesn’t mean regulators shouldn’t act as if they’re operating without a net.

3. Reiterate the primacy of the three key regulatory ratios. That would be Tier 1 Capital, Total Capital, and Leverage. The single biggest impediment to credit intermediation today is the uncertainly the administration has created regarding which numbers count, and how high they’re supposed to be. This has to end!

The confusion has bankers paralyzed. Officially, to be considered “well capitalized,” a banks needs to maintain a Tier 1 capital ratio in excess of 6%, total capital of 10%, and a leverage ratio of 5%. But regulators have their own “whisper numbers.” So unofficially they are requiring large banks maintain Tier 1 capital ratios in excess of 10% rather than 6%.

As I have said in the past, this capital bulk-up can be sustained in the short run. But longer term, with the rest of the world’s banks operating with Tier 1 capital minimum of 4%, it can’t.

Maybe the administration can engineer an increase in the Basel minimums to 6% for Tier 1 and 10% for total. In that case, U.S. banks could be held to a higher standard (say, 8% Tier 1) and not be at a significant disadvantage globally. But I see zero chance other countries would be willing to raise the Tier 1 minimum to 8%. Absent that, U.S. banks, forced to maintain 10% Tier 1, would be at an unacceptable disadvantage if they had to maintain a Tier 1 ratio more than 200 basis points higher than non-U.S. banks’.

4. Change the methodology for the establishment of loan loss reserves. The accounting justification for loss-reserve accounting is that it’s a way to match current-period revenues with expense. Lenders know loans booked today will result in some level of losses in the future, so they estimate what those future losses will be when they book the loan. But how do they come up with that estimate? By current accounting rules, they base it on actual, historical losses, by loan category.

So when losses rise (as they have over the past two years) so do the reserves required for all the loans on the bank’s books. The effect is pro-cyclical: reserves rise fastest during the bad times, and run down during the good. Earnings thus tend to be understated at the bottom of the credit cycle, and overstated at the top.

That’s not good. In reality, reserves are just a de facto form capital, but on the other side of bank’s balance sheet. Bankers and accountants have debated many options for determining loss reserves. No method is perfect. However, the current, pro-cyclical, method is among the worst, and clearly needs to be changed.

Our suggestion: bank regulators should establish reserve levels by loan type (commercial, credit cards, real estate, construction, and so on), and then maintain those loss levels throughout the cycle, even as actual losses ebb and flow. That way, during credit bottoms (like now) bank earnings would still suffer as loan loss provisions rise to cover cyclically high chargeoffs, but earnings would not be further reduced by redundant reserve builds.

5. Eliminate interest rate distortions by the government. Fannie and Freddie have got to go. They should be put on a calibrated, multi-year wind-down program so that mortgage rates can be freely set in an unfettered market.

6. End money market mutual funds’ free ride. Talk about a bailout that didn’t get enough attention! Since the fall of 2008, money market funds have received the backing of the U.S. government--and haven’t had to pay a dime for it. One of the most appalling aspects to the money-market fund business is the myth that the funds are always worth exactly $1 per share, regardless of the underlying value of the funds’ assets. Meanwhile, the funds get free insurance and yet are essentially unregulated. This free ride should end. I believe MMFs should be quoted at their fair market value, to instill some market discipline. And if they want to be supported by the feds, they should have to accept all the strings that that comes with.

7. Impose tighter leverage limits in investment banks. In hindsight, one of the biggest regulatory mistakes of the past decade was the S.E.C.’s decision to allow investment banks to maintain significantly higher leverage. Some ended up going as high as 40 to 1. High leverage allows relatively small problems to morph into catastrophes. We believe the maximum leverage should be set no higher than 20 to 1.

8. Get rid of rating-based triggers. Again, with hindsight, one key cause of the meltdown was the poor performance of the rating agencies, particularly with regard to their ratings on new products such as CDOs. No one can expect the agencies to be any more clear-sighted in the future than they have been in the past. We can, however, prevent the effects of their misjudgments from cascading through the financial system.

The best way to do that is to eliminate all triggers and mandates based on agency ratings. For example, some pension plans can only invest in AAA- and AA-rated securities, and must divest a security immediately if it’s downgraded to below that. That makes no sense. Such rules give financial markets participants a false confidence in the safety of their investments—and then too little flexibility when the ratings turn out to be wrong. Fixed-income managers should have to do more than blindly follow ratings. And the ones that can’t? Fire ’em and hire ones who can do their own work.

9. Credit default swaps should be traded on an exchange or through a clearing house. CDS did not cause the financial chaos many predicted they would, but given the market’s tremendous growth, it needs to be more tightly regulated. I believe “vanilla” CDS should be traded on an exchange to bring better transparency to pricing. Customized CDS could still be written, but should be traded through a clearing house.

10. Credit unions should be taxed. If there were ever an example of structural inequity in the financial services business, the credit union system is it. Credit unions pay no taxes, yet longstanding restrictions on whom can join them and what products they can offer have been steadily eroding for years. Many of these institutions have grown well beyond just serving the core group of members they were founded to serve. Credit unions are said to be wildly popular with their members. Fine. Just make them pay taxes.

Those are our ten reforms. And note, please, what we did not include: No new tax on the 50 largest banks, no new regulator, no limits on hedge funds, private equity, or proprietary trading--other than what would be determined as an unsafe and unsound banking practice.

The key to our proposals is they would create regulatory efficiency clarity, and clean up ambiguity and redundancy. The result would be a better, safer financial services industry, a boost to banks’ confidence, and an increase in their willingness and ability to lend.