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.

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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.