US Financial Reform Options

There is a consensus that Financial Reforms in the US are necessary and various Obama administration officials including SEC Chairman Shapiro, Treasury Secretary Geithner and the President himself have acknowledged the need. Certainly the US and the rest of the world can ill-afford another “financial bubble” exploding in the next 5-10 years. Simply the ability to react and control another bubble would stress severely US and other governments which have spent much of their debt capacity to tackle the current financial crisis. So let us consider the major options.

Six major Financial Reforms have been discussed in the press and economic/financial forums. Here is a brief summary of these major options:

Take away “too big to fail” by breaking up large financial institutions.

The whole problem with the current crisis is that AIG, Fannie Mae, Freddie Mac and even Lehman – were too big and interconnected to be allowed to fail. Given globalization plus complex and tightly integrated financial instruments even relatively small financial institutions can, with the right “wrong” leverage, set off a domino-series of failures. So this option, though it would help alleviate some of the rescue problems ,could not be expected to work completely for 3 reasons:

i)as noted even smaller institutions using derivatives and other complex instruments could bring down a swath of companies;
ii)the Mortgage meltdown has shown that not just one or two but nearly a dozen financial institutions of large size are insolvent and nearly failed. This strategy might work well in the case of 1 or 2 isolated failures; but if history repeats itself (and the Finance community, large sectors of which are still immune to taking any responsibility for the current crisis, have all the wherewithal to duplicate the current fiasco), so then the country would be presented with a group of financial institutions “too big to fail”;
iii)the financial community would resist break-up with all its lobbying and not-insubstantial political influence.

So this first option has somewhat marginal returns for high resistance costs.

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“Pay to Play” becomes the new financial rule of the road

Currently there are five major financial agencies each regulating a specific range of financial transactions but for an often overlapping set of financial institutions with widely varying degrees of effectiveness and mutual co-operation. This is the great structural flaw in US financial regulation that makes enforcement increasingly ineffective:

All five of the these agencies are really devoted to regulating a relatively small number of financial institutions. So two reforms are needed. First, some rationalization of the regulators  so they can control and manage  financial integrity more effectively. Second, financial  institutions should pay directly for their regulation, insurance and control. Thus Financial institutions would pay  into two funds – a general regulatory fund and a new government FIIF- Financial Instruments Insurance Fund. Say you are a financial institution dealing in stocks, options, and some derivative instruments – then each transaction would make a percentage  payment into the general regulatory fund  and then another %fee into  FIIF insurance fund based on the instrument’s risk profile and the companies past history of “objectionable behaviour” .  For new and untested financial  instruments the reinsurance costs would be higher. The argument against this “pay to play” policy are again 4 fold:

i) Financial institutions would just pass on higher costs to the business community while retarding the free flow in financial markets;
ii)financial institutions which already have a “close relationship” (untoward political influence) would now see that unhealthy influence exaggerated as they “got what they paid for”;
iii)US financial institutions would be at a disadvantage and would lose market share as their own companies as well as foreign ventures would just go to the country with the lowest financing costs;
iv)having a FIIF insurance fund would cause more moral hazard and sloppy risk taking behaviors.

The counter arguments are, in order, that higher costs would eliminate risky and/or cost ineffective financial instruments; the tax would go into a general pool so that there could be no identification of payments with players among the agencies – so regulation would be no worse than now; yes, there might be a flight from US capital markets initially – but “you get what you pay for” should eventually take hold; and without some regulation and severe restriction on who could participate in markets based on their behaviors – then yes, moral hazard and risky-to-disaster game playing would continue.

“Pop the greed bubble” by managing financial compensation

The critical measure would be to establish  6 Sigma Compensation.  6 Sigma Theory says that when executives perform at 6 standard deviations they make only one wrong decision in a million. For this level of performance, financial executives would be entitled to the square of their level of performance. So for 6 sigma performance a financial executive should make  in total compensation 36 times the average pay  in the organization. For Goldman Sachs employees who average $675,000 in total compensation this means that CEO Lloyd Blankfein should make $24.3 million while his total compensation for 2008 was reportedly $43 million. Six Sigma Compensation allows for no stock options but does allow and recommend payment in stock for top executives(but shares cannot be sold until held for at least 2 years). 6 Sigma Compensation also requires direct performance measures for all managers whose  level of pay exceeds 3 sigma(9 times the average wage in the organization) – these public performance measures then determine the final level of pay. Finally there is a teamwork bonus. Since 5 as well as 6 sigma performance are extremely hard to achieve – the pay to managers in these categories has to be matched with teamwork bonuses to all the manager’s subordinates  who surely contributed to the executives stellar performance. This would be a team bonus at double  the 5 sigma compensation received  and a team bonus at quadruple the 6 sigma pay levels. So CEO Blankfein would have his pay reduced to $24.3 million but would be able to distribute among all his subordinates $97.2 million any way he so chooses- just so long as the bonuses do not cause any one employee’s compensation to exceed the current $24.3 million  maximum for Goldman Sachs (again that maximum is determined by the average compensation at Goldman from the previous year but note those executives in turn trip off another team bonus).  As seen in the Press, there is likely to be fierce resistance to compensation limits or regulations in 3 ways:

i)Emotional gut spilling, especially from the financial community. “Too hard to understand and implement”. “How dare the government cap how much a man can make! Its plain un-American”. “The decisions I have to make are at a level and category beyond the ordinary ken … I deserve every penny I make”. “This is blind leftist tinkering and ruination of capitalism”. “And Yada, Yada, Yada, yaaaah”;
ii)the financial community will have gutted  and gotten around these compensation limits within two years max. Their will be all sorts of highly paid “consultants and contractors”. Executives will get super deluxe “retirement packages” and then will be hired back as consultants for enormous sums. “This compensation system is so simple to game and bypass its a sham”;
iii)Again, top notch financial executives will just leave the US and there will be a brain drain.

However, again there are some plausible rebuttals to these “game and bypass” objections.
First, since the financial community is still on trial for getting away “Scott Free”  for causing a Gigantic 2-3 year recession and have reduced the world’s net worth by 20-60% depending on circumstances in less than a year. Financial guys and gals have to think twice about their standing in the social economic world. Doctors, engineers, and soldiers who make real life and death decisions can only hope to make a fraction of a typical financial executives annual compensation. This will obviously grate on the social fabric over time. Second, one can control financial game playing by making severance and contractors/consultants pay subject to the same annualized maximums and total compensation limits provided for by 6 Sigma Compensation. Finally, let the markets work and as David Brooks of the NYTimes might say – let the stupid, Masters of the Universe financial risk-takers take their excesses overseas and see a)what a reception they receive and b)how long they last.

Re-Regulate Intelligently

The whole financial system is not working precisely because the vaunted open, transparent, and impartial financial markets are anything but that. Financiers have found that competitive advantage is derived from having closed, secretive, and insider-like information. Also they are much too eager to unleash beta financial instruments(think complex derivatives and other securitisation vehicles) upon the world for the hugely profitable advantages they gain. If a financial instrument breaks/fails, the financial musical  chairs game is who to palm the damages off on – One of the their own or more likly The Commons as a common target as is J.Q. Public. There are a number of other obvious re-regulation targets: leveraging limits for financial institutions are  required as well as controlling perversely matched markets(think financial rating agencies). Basel 2 risk regulations hardly worked and that is not encouraging because these global risk management and disclosure rules have been in the works for at least a decade. But clearly, the key to effective re-regulation is to make all financial markets and instruments as open, transparent, and “fair trading” as they are claimed to be.
The two major objections to re-regulation will be:

i)”we have seen all this before it didn’t work then and it wont work now”
ii)”Time to pull up stakes”

The response to these objections are hard and then  easy. First, there are too many reports and dissertations to be able to show here that deregulation was one of the key factors that contributed to the size and depth of the current financial fiasco. Just google “Financial Deregulation” in general and at many a university website(we have provided just two here). And secondly good riddance to bad biddance.

Make Fiduciary Trust the Goal again

Missing from the financial (and legal, for that matter) professions is a Hippocratic oath equivalent – “do no harm to the client”. For example, conduct in the medical profession is judged and may be censured based on this standard. It is this type of trust standard that underlies confidence in a profession. But trust has been all but abandoned in the highest realms of Finance. Fiduciary Trust plays second fiddle to own account transactions, “front running”, and blatant hawking of highly profitable bait and switch mortgage and other financial instruments. Trust within the Financial Community itself was gutted by savage short-selling, rumor twittering, and zero-sum (“I win means you have to utterly lose”) and made the crises many times worse than it had to be. It was a dog eat dog evisceration. No wonder credit markets seized up – bankers could not trust each other. Now it is well nigh impossible to legislate trust. But at least some of the necessary conditions can be laid in. Web-available ratings of financial institutions based on Fiduciary Trust and other measures of financial efficiency and effectiveness for bank, mortgage, insurance and other major financial markets. Removal of own account transaction privileges for all financial institutions. No more financial prosecutions with “no admission of wrong doing” but only a financial payout – executives responsible must be prosecuted and incarcerated just like “petty” criminals. White collar crime cannot be allowed to go “scott free”. Of course the objections to this type of reform will be predictable:

i)Financial markets are not for fuddy duds and namby pambies – they are Microsoft high and hard fastball markets where people looking for Fiduciary Trust and other “win-win” notions should be putting their money in guaranteed trust certificates and/or should just stay away;
ii)Financial markets, when they are not regulated to death, are Darwinian efficient. They inevitably root out the weak and only allow the strong, efficient and effective to survive. Look what happened to Bear Stearns and Lehman Brothers – the weak and inefficient got weeded out and all their stockholders and employees got their just financial come-uppance;
iii)if its not broke (and the markets are not broke, just over-regulated) don’t fix it;
iv)”Trust?? … Who? Me ? Worry ?”

Actually, combined with Pay-to-play, public performance  on Financial Institution measuring their ability to deliver   Fiduciary Trust and other measures of Financial effectiveness might have popular appeal. And the Obama people really know how to do the Web well.

Summary This review has sought to show that the financial reform options open to the Obama Administration are fraught with difficulty. There will be great objections among the financial community. They will argue why us? They will argue that reforms and regulations simply do not work.They will certainly argue that one of the key US industries, Finance and Banking, cannot afford to be way laid in these tough economic times by new regulations. Clearly no one strategy will work on its own and compensation/greed reform and re-regulation are paramount. But more critically I ask governent and business alike how soon and how big do you think the next financial bubbles will be without meaningful regulation? However, I just feel compelled to give the last word to a Mr. Schadenmund. “Listen you SOB Leftists, we have your numbers. As long as it takes a billion dollars to get elected President, we have the power. What do you think that Jay Leno’s late night joke about Senator Chris Dodd D-Conn being shaken out of the pocket of an AIG executive at an airport inspection station was all about ? The joke was ours. Just a jolly chuckle to remind people where and by whom the “public good” shots get called.“