Tuesday, November 17, 2009

Banking Sector Fix In Six Steps: Roger Lowenstein

Financial reform seems to be flailing. 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 a future bubble.

The House and Senate are squabbling over which federal agency should take the lead in supervising banks. The administration, as well as the Congress, have fallen into the trap of trying to fix everything. Instead, they should agree on the most important remedies.

The crash exposed six serious problems:

No. 1: Mortgage regulation was too lax and in some cases nonexistent.

No. 2: Capital requirements for banks were too low.

No. 3: Trading in derivatives such as credit default swaps posed giant, unseen risks.

No. 4: Credit ratings on structured securities such as collateralized-debt obligations were deeply flawed.

No. 5: Bankers were moved to take on risk by excessive pay packages.

No. 6: The government's response to the crash also created, or exacerbated, moral 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.

Pay Back

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 "liar" loan or a mortgage with no money down. Congress should ensure that the reforms stick by legislating a simple 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 vowed to raise standards for banks when the world economy recovers. The U.S. shouldn't wait; Congress must 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 throw out model-based approaches that set leverage ratios according to Monte Carlo-type formulas. These formulas treat financial assets like random pegs that can't all default at once. (Memo from the recent crash: they can.)

Adult Supervision

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. American International Group Inc.'s credit default swaps could have been struck on the moon and it still would have needed a bailout. It got into trouble because it had to post tens of billions of dollars in extra collateral as its positions went sour. Thus, the relevant question is the amount of collateral supporting each trade.

David Moss, a regulatory expert at Harvard Business School, has suggested an ingenious solution. Exchanges should require traders to post significant collateral, and Congress should mandate that, for derivatives traded in back alleyways or elsewhere, traders adhere to the highest collateral minimums set on the exchange.

Don't Rate

As for No. 4, Moody's, Standard & Poor's and Fitch Ratings fed the mortgage bubble with unconscionably 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.

At the very least, the U.S. should stop endorsing this conflict-ridden arrangement. The SEC designates certain companies as "nationally recognized," and its stamp of approval qualifies the firm for many lines of business. Congress should mandate that only rating companies paid by disinterested parties can qualify for official status.

The fifth issue, inflated compensation, is endemic to all industries, not just financial firms. But it encouraged excessive risk-taking, and thus high leverage, on Wall Street.

The government is trying to restrain compensation in various ways, such as rulings from the pay czar and Fed guidelines for banks.

They're Back

They aren't working -- witness the return of big bonuses on Wall Street. Moreover, the new fixes suffer from micro- management. We don't want bureaucrats sifting through every paycheck.

A simpler fix would be to require shareholder approval for outsized pay packages, say $5 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 $4,999,999 a year. And for those who get shareholders to approve a greater swag, that's the free market at work.

Last, in 2008, 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.

Secrets Kept

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 hefty 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.

As bad as the financial crisis was, we don't need the government running Wall Street from the inside, nor do we need new federal agencies or bureaucracies. We need a few carefully chosen rules to reassert proper incentives and proper limits.