Crooks and Scandals: Punish One at a Time

In my previous blog I suggested that business regulation is about a decade behind the times for financial services, citing AIG as an example of a company that failed when it overinvested in non-insurance assets. We got into this situation when the Gramm-Leach-Bliley Act of 1999 deregulated financial services but the government structure of oversight failed to change. There is nothing wrong with regulation as long as it reflects the current strategy of an industry. The problem is that Congress has not really adjusted the regulatory responsibilities since the passage of the three securities acts (1933, 1934 and 1940) and the banking acts (1864 and 1913); there never has been federal oversight of the insurance industry.

What we need to do once the dust settles is to refocus on the functions of these industries in the 21st century and not of one, two or even three generations earlier. As I wrote in my book, Is U.S. Business Overregulated? (York House Press, 2008), we need the appropriate level of consolidated regulation, probably by categories of risk. First, each type of investor should receive a directed form of regulation by risk category.

For institutional investors, management of financial services businesses in terms of such risk categories as-

  • Insurance risk for the safety of customer funds that are on deposit with a financial services firm. This would include the segregation of customer funds and administration of account insurance (like the Federal Deposit Insurance Corporation).
  • Business risk to protect the integrity of the intermediation process used by all financial services companies. This would include assurance that adequate collateral exists for loans, that appropriate due diligence has occurred in deciding whether to establish and continue relationships with customers, and that necessary documentation exists to support financial transactions.
  • Systemic risk for the security of the financial system. This would involve uniform capital requirements, payment system regulation, and the monitoring of financial system liquidity.

For individual investors, depositors and consumers, protection for those who are too weak, uninformed and scattered to defend themselves. The securities industry has long recognized that institutions and other sophisticated market participants do not need the same regulatory protections as unsophisticated investors. Financial services for retail customers would be subject to regulation and the protections afforded such investors, policyholders and depositors across product lines. This would include the prevention of deceptive sales practices, credit counseling prior to the acceptance of a loan, and prosecution against the “churning” of securities and of fraudulent profit claims.

The single regulator approach permits financial regulation from the larger perspective of the strategic objectives and decisions of a financial services organization, rather than of specific product lines and operations. The model would be the Financial Service Authority of the U.K. British regulators have learned from long experience that, while there will always be scandals and failures, each should be dealt with accordingly and with remedies specific to the circumstances. This is in sharp contrast to the current American approach to business regulation: that fraud and the misappropriation of company funds can only be prevented by severe civil and criminal penalties. In my next blog, I will discuss some related issues to the current financial situation.

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Bad Regulation: AIG and When Chickens Come Home to Roost

Just how out-of-date is our regulatory system? Given the current economic crisis, we are finally hearing calls for fixes to the government oversight of banks and other financial institutions. If we start with the deregulation of financial services companies that was accomplished in the Gramm-Leach-Bliley Act of 1999, we’re about a decade behind in terms of financial regulation. Why? Because the old structure was retained, with the Federal Reserve System and the Comptroller of the Currency regulating the commercial banks, the Securities and Exchange Commission overseeing the securities industry, and state insurance commissions responsible for the insurance industry.

Meanwhile, financial companies could enter any financial business in the search for profits and market share. That’s what got AIG (the American International Group) into trouble. It established an investment bank behind its rather dull but competently managed insurance businesses, which managed to eventually lose more than $18 billion (the reports for the most recent three quarters of operations). This AIG unit wrote credit-default swaps (CDS), a guarantee against default, with an exposure based on the notional (face or stated) value of nearly one-half trillion dollars! A CDS is a contract between two counterparties – that is, buyers and sellers – in which the buyer makes regular payments to the seller in exchange for the right to compensation if there is a default or “credit event” in respect of a third party (sometimes called a “reference entity”).

As poor credits including subprime securities began to fail, AIG hit the wall. The company couldn’t pledge enough collateral with its counterparties, prompting credit rating downgrades and more calls for margin. The New York State Insurance Commission actually did a fine job in regulating the insurance groups of AIG, and it appears unlikely that any loss will occur in those businesses. It is the investment bank – not subject to the insurance regulators – that was the culprit, and the cause of the requirement for an $85 billion credit facility bailout from the Federal Reserve.

This is the time for Americans to reconsider our approach to financial regulation, and indeed, to all business regulation. For the financial industry, we need the appropriate level of consolidated governmental oversight, probably by categories of risk. In my next blog, I will discuss a more thoughtful approach to regulation and suggest appropriate organizational ideas.