Download 2009 Aug 28PaulBennett - Needed US Regulatory Reforms

Perspectives on Needed U.S. Regulatory Reforms
Paul Bennett, CFA Society, August 28, 2009
Summary
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The current recession was precipitated by a housing collapse exacerbated by
severe structural problems in the U.S. banking industry. Now it has reverberated
around the world. We need to fix this, for the sake of our pocket books and our
reputation in the world.
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Emergency monetary and fiscal policy initiatives have been enacted promptly to
counteract the rapid contraction, and these appear to be working.
– But rebuilding fundamental confidence will require rebuilding the US
banking sector in a way that plainly works.
– In my view, three areas of reform should be at or near the top of the list,
for prompt attention by Congress and the Administration:
Some Key Needed Reforms
I.
Executive compensation methods at banks backed by taxpayers must be made
appropriate, to reinforce executive incentives that are consistent with a stable
and resilient market environment.
II.
Capital requirements for large financial organizations must be made much
tougher. Firms with little capital have all the wrong incentives.
III.
Regulators must take a more active interest, from a safety-and-soundness
perspective, in how financial instruments trade. It is essential to assure that
markets are designed to stay robust during periods of extreme uncertainty and
price volatility.
I. Executive compensation methods at large banks backed by taxpayers must be made
appropriate. Traders, deal makers, and others rely on a financial organization’s capital,
infrastructure, and reputation.
•
Shareholders, not their employees, are fundamentally entitled to profits.
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Corporate boards must avoid being compliant or inbred, in the face of executive
pay demands.
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For example, boards must avoid over-reliance on compensation surveys, which to
often do not indicate “competitive” compensation levels but rather reflect how
commonplace overpayment is. The “market” for executives is sometimes quite
dysfunctional, with people competing to overpay colleagues with other peoples’
money.
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While every employer wants the best workforce possible, including the best CEO,
extremely large pay packages reflect weak procedures for negotiating.
•
Regulation may have a constructive role in protecting shareholders and taxpayers
from board giveaways.
•
In my view, appropriately restricted stock is still the best way to compensate
executives.
•
Hedge funds and boutiques provide alternative platforms where entrepreneurial
employees can take risks and add value to the economy.
An important consideration is the difficulty of regulating very large financial
institutions, which are implicitly government backed but which rely on risk-taking
traders and managers to earn profits.
•
While senior management can demand internal risk reports and set position limits,
when push comes to shove in the world of Wall Street competition, a trader
bringing in big bucks, which will raise his boss’s and his boss’s boss’s bonuses, is
very likely, one way or another, to be given the go-ahead to take on excessive
risk.
•
Putting the larger organizational capital at risk is how a trading desk or lending
operation make money.
In effect, the really difficult “regulation” problems start inside a banking
organization, and it requires a high level of management skill and determination to
say “that is too much risk, that is enough profit”.
•
Even shareholders may not be sufficiently motivated to limit risk, given their
ability to diversify and their portfolio risk perspective.
•
Thus it is the management, with a disproportionate stake in the overall firm’s
survival and success, who must draw the line.
•
If management itself fragments and begins operating in a “me-first” manner, with
the overall organization’s capital at stake, bad things can happen.
•
Risky loans, oversized trading bets, instruments with shaky fundamentals, and
artificially pumped liquidity and prices will result from aggressive individuals
pursuing their own personal goals using other people’s money.
•
While compensation of senior officers should remain the prerogative of the board
of directors, the economic consequences of mistakes at the individual firm level
creates a public interest in seeing that boards carry out this role effectively.
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II. Financial organizations’ capital requirements must be made much tougher.
Phony economics: capital is “too costly”
•
Partnerships used to provide better oversight of capital, since partners had strongs
incentives in addition to requisite knowledge to closely monitor organizational
risk.
•
In these contexts, capital ratios were often voluntarily much larger than today.
•
The “cost of capital” in large publicly held banks today represents a difficulty of
finding investors willing to delegate their wealth to others whom they cannot
adequately monitor.
•
Far from being an argument to allow more leverage, this difficulty of bringing
capital up to a publicly acceptable level relative to assets represents the freemarket fundamentals telling us that the organization is too large.
•
One way around that is for the organization to right-size itself.
•
If there are consequences for the ability of the market to intermediate certain
types of risk, then we should listen to that market signal.
•
To those who argue the economy will suffer, I would respond that if there are
legitimate risks to be taken – and I believe there are many profitable opportunities
arising every day – then let entrepreneurs put their own capital at risk directly,
rather than trying to benefit from putting other people’s money at risk in ways
they can’t understand.
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The required return on less leveraged capital is proportionately less
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Just as executives are prone to become over-compensated for taking risks using
the capital of stockholders at large banks, so are department managers within
banks anxious to increase leverage if they have others people’s money at stake.
•
Restricted equity capital in a context of solid capitalization provides the very best
alignment of incentives for executives, traders, and others.
•
Boards and top management must be strongly motivated and empowered to
protect organizations against phony asset valuations.
•
Close monitoring of valuations and setting compensation parameters go hand-inhand.
•
Banks who implicitly expect to be too big to fail cannot be the leading-edge risk
takers in the economy.
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•
Boards and top management must be strongly motivated and empowered to
protect organizations against phony asset valuations.
•
Close monitoring of valuations and setting compensation parameters go hand-inhand.
•
Restricted equity capital in a context of solid capitalization provides a reasonable
alignment of incentives for executives, traders, and others. If stock paid as
compensation cannot be vested or sold for, say, five years, then senior
management who takes excessive risk cannot “take the money and run”. Indeed,
they will have a clear incentive to stay and manage in a responsible way,
implicitly protecting their firms but also the economy.
III. Regulators must take a much more active interest in how financial instruments trade.
Markets must be structured to be more robust during extreme volatility.
Reliance on OTC markets should imply significantly higher capital requirements
•
Clearing and settlement is part of the issue.
•
But at least as important, OTC markets tend to be oligopolistic. That is, dealers
make money by controlling order flow and information in ways that are
impossible on exchanges. The lack of openness creates problems when the
dealers or other major traders themselves become capital constrained in a crisis.
Banks developing markets in new instruments (or in re-shuffled, re-leveraged old
instruments) have an incentive to maintain business control over trading in the market
for those instruments.
•
Keeping the instruments (which the banks themselves typically
underwrote) complex and opaque, while reducing natural market liquidity,
somewhat ironically makes trading more profitable, by creating more
asymmetry of information in the marketplace.
•
Competitors find it difficult to compete in market making even when the
instruments are performing well.
•
But the liquidity in such markets is highly dependent on the originating
bank. Questions about the instruments lead to questions about the
underwriter/market makers. This liquidity is fragile.
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•
To the extent there are practical ways to keep instruments simple and
transparent, the markets in them will be more robust, even in times of
general market uncertainty.
•
Economists might argue that issuers should be naturally averse to having
its securities more complex and less liquid than necessary. Unfortunately,
this is not always the case. Issuers and underwriter-dealers often have
complex relationships, and issuers will generally tend to take the advice of
underwriters about how to structure offerings. While economic logic
argues that a business firm offering illiquid liability instruments to the
marketplace may have a higher overall cost of capital, this is apparently
given insufficient consideration by some businesses when they are issuing
debt. Instead, the underwriter-dealer’s preferences end up winning out all
to often, sometimes in the guise of professional advice.
•
Issuing unnecessarily complex and illiquid securities should be viewed as
bad management practice that hurts shareholders’ interest, and at some
level hurts the resiliency of financial markets.
•
Where the “issuer” is not a company but a portfolio of assets, often
controlled by the underwriter, the securities regulators should take a hard
look. For example, portfolios of subprime mortgages in trusts giving off
cash flows sliced and diced into complicated tranches were arguably
destroying market liquidity, for the sake of short-term marketing and
placement.
In short, the principle that unnecessary opaqueness or complexity of traded assets can
create dangers needs more attention by regulators.
Outlook
As a group, economic forecasters are becoming more optimistic, with the consensus
beginning to be that the second half of this year will see moderate growth, possibly in the
2-3% range. Some central banks are beginning to normalize overnight interest rates and
thinking about how to withdraw liquidity as recovery becomes clearer.
•
The damage to bank capital and public confidence, as well as lingering problems
in some sectors and economies, may slow recovery somewhat.
•
I am hopeful that in the U.S. businesses’ cautious inventory and labor policies
during the downturn will contribute to a healthy upturn.
•
One question is whether the problems that helped accelerate the contraction –
problems with the banking and regulatory system – will evaporate from our minds
as soon as the economy recovers.
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This is a possible political outcome, but investors will not soon forget and forgive
the recent debacle.
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Genuine reforms that strengthen the US financial system would tremendously
boost the confidence of investors worldwide; and the US is highly and indeed
increasingly dependent on worldwide investor confidence.
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So while we have wisely not rushed into financial regulatory reform, as the
economy starts to look up, intelligent reform should be a matter of highest
priority.
Significant change is needed in the incentives bankers and traders face, so that risk
strategies endangering the financial system are not attractive.
•
Capital ratio requirements must increased, particularly for instruments relying on
the fair-weather liquidity of inter-dealer markets for complex instruments. If that
reduces some trading, so be it. Traditional banking can handle the slack.
•
Valuations of assets must be scrutinized by regulators, so that the capital
requirements are not a mockery.
•
Liquidity of instruments currently traded on OTC markets must be enhanced by
moving as many of them as possible to public exchanges, notwithstanding the
protests of bankers who have benefits from the reliance on inefficient market
practices.
If we do what is necessary, confidence will return.
•
The largest banks may not be so dominant based purely on size, vast
technological capabilities, and their ability to diversify risks across a huge range
of exposures.
•
Smaller banks may have a better chance to compete where they have better
customer relationships and knowledge, which, after all, is what banking is about.
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Securities exchanges can play a broader and more intelligent public role than they
have in recent years, and many instruments that in recent history have been
confined to OTC markets can be easily shifted to public exchanges, benefiting
investors palpably and strengthening the ability of financial markets and firms to
withstand times of stress.
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