Possible Outcomes from the 2008 Financial Situation: Part II

Is U.S. Business Overregulated?Our last blog discussed three areas of likely political and regulatory change as the result of the financial crisis of 2007-2008. Here are four more areas for change.

4. The Organization of Regulation. Although functional regulation continues in the financial industries, the passage of deregulation through GLB permits financial companies to enter any financial area. This situation of inadequate oversight may have been a major element in the 2008 credit crisis and strongly suggests the need for consideration of a consolidated regulatory scheme similar to that used by the Financial Services Authority in the U.K. (For a more complete discussion, see James Sagner, Is U.S. Business Overregulated? How Government Destroys Our Ability to Compete Globally, York House Press, 2008, particularly Chapter 7.) The matching of the integrated strategy permitted by GLB to an appropriate regulatory structure has been suggested by Secretary of the Treasury Henry Paulson and others, and is likely to be considered in the next Congress as omissions and errors made both by the regulators and the companies are investigated.

5. Government Market Actions. The theory of a free market clearing supply and demand at an equilibrium price may not be working in certain situations, and governments will not stand back and watch chaos and instability destroy long-established consumer expectations and behaviors. The most obvious recent problem has been with commodities, from metals to energy to food, although the precise role of speculators and hoarders has yet to be definitively established. In any event, governments will stockpile, subsidize, set price floors and ceilings, prosecute and change the procedures by which these products trade.

6. Restrictions on Business. Congress is loath is interfere with the free market system and realizes that it knows less than business managers how companies should operate. (Most Congressmen have never worked in the corporate world; for statistics on the professions of the current Congress, see “Membership of the 109th Congress: A Profile,” CRS Report for Congress, pages CRS 3-4, at www.senate.gov/reference/resources/pdf/RS22007.pdf). The disastrous post-World War II experience in Great Britain with nationalization ended with Prime Minister Thatcher’s decision to privatize most of British industry, and we are not about to go back to the days of a Labour Party under Prime Minister Clement Atlee. However, there is considerable pressure on executive pay, particularly regarding disclosure and limitations.

It is possible that many companies could be subject to new rules as the asset-purchasing program of the U.S. Department of the Treasury begins. Executive pay is affected in several ways, including limitations on tax-deductible compensation (now $500,000). Board committees that approve executive compensation may be required to examine the risks a senior manager might be motivated to take on to meet his/her goals. Members of Congress have indicated that the current financial rescue package approach to compensation could be extended to all publicly-traded companies.

7. Government Senior Administratorship. One of the most unfortunate outcomes from this entire credit market disaster has been the growing recognition of the weak stewardship at certain of the regulatory agencies that should have been monitoring the situation. The country does have two strong leaders in Chairman Bernanke at the Federal Reserve and Secretary Paulson at the Treasury. Congress may begin to realize that awarding senior-level jobs to former colleagues, the relatives of former cabinet secretaries, or other political hacks is a poor method to choose Executive Branch senior managers.

Just as some states write qualifications for cabinet-level positions, the Congress may choose to insist on banking, accounting, legal or other relevant agency-specific experience for these critical positions. Furthermore, the old tradition of rewarding cronies who were defeated in a recent election must be very carefully examined; the voters probably knew what they were doing, and the framers of the Constitution never intended the Senate to be a rubber stamp in approving jobs for the pals of the President.

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Possible Outcomes from the 2008 Financial Situation: Part I

We have discussed the financial crisis in previous blogs. Inevitably, several changes will be considered by government policymakers and the private sector as the result of the events of 2007-2008. Political considerations will drive these reforms regardless of issues relating to free markets and capitalism.

1. New Regulation. There will be new financial regulation, including rules to reduce leverage and to control markets that have been unregulated. The use of 30 to 35: 1 debt-to-equity financial leverage used by certain securities firms to enhance returns will be limited to the same rules as apply to banks, about 10:1. Unregulated instruments like the credit default swap market will be subject to controls, somewhat like the rules that exist for the futures markets. Banks may be limited in their securitization activities and could be forced to retain ownership of portions of loans as an inducement to better lending practices.

2. Existing Regulation. The operational regulator for banks is the Comptroller of the Currency, an agency that has been in existence since the American Civil War. (The Federal Reserve is a strategic regulator for the entire financial system as well as the central bank of the U.S.) The supervision expected of banking practices includes the appraisal of asset quality, including the terms and documentation of loans; the competence of management; and sensitivity to interest rate, operating and other risks.

New levels of examination will be required, including analysis to predict situations that may lead to non-performing loans, verification of the value of collateral, proof of earnings and assets, review of performance on loan repayment, and other steps to improve the balance sheets of banks. This should prevent future distressed bank sales like Wachovia Bank in 2008, but will inevitably deny credit to marginal borrowers who may be struggling to buy their first homes or keep a business afloat.

3. Government Political Actions. Government helped create the current financial problems largely for political reasons. Some examples:

· To satisfy homeowners: deductions for homeowners on mortgage interest and property taxes on residential real estate
· To appeal to those at lower incomes: encouragement to Fannie Mae and Freddie Mac for loans to borrowers with questionable credit histories
· To induce borrowing activity: unrealistically low interest rates as set by the Federal Reserve
· To placate business managers: the business deduction for interest on debt

Political decisions will again be made to satisfy angry constituents and place blame. It is difficult to know who will bear the brunt of this anger, but a reasonable forecast is that the financial industry will be the target. The restoration of the pre-deregulation regime is unlikely – the period before the Gramm-Leach-Bliley Act of 1999 (GLB) – but some changes are inevitable; see the following section on the organization of regulation. However, we must remember “the law of unintended consequences” which basically states that passing new regulations inevitably causes other (and possibly worse) problems.

Additional possible changes will be discussed in our next blog.