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In today’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. www.financialstability.gov/docs/regs/Fin...

Full Disclosure: No Positions.