The Basics of Financial Regulation

Another cycle of suggestions for financial regulation is upon us. Treasury Secretary Hank Paulson is giving a major speech today, June 19, 2008, calling for increased oversight of financial institutions on the part of the Federal Reserve System and for an understanding of the need for regulators to intervene in the banking system to avoid unnecessary systematic risk. Recently, Tim Geithner, the President of the Federal Reserve Bank of New York, in a speech given in New York, argued that investment banks should operate under the same uniform regulatory framework as other financial institutions so as to encourage appropriate liquidity, capital, and risk management practices.

I believe that it is a certainty, coming out of the financial dislocations of the past 12-18 months, that a new, modified regulatory structure will be forthcoming out of Washington. It is highly unlikely, however, that any action will be taken before a new President and administration is seated. Treasury Secretary Paulson is trying to impact the future by laying out ideas that will serve as the basis for an agenda of the discussions that will follow. How much impact he will have on these future discussions remains to be seen. It is the only hope someone going out of office has of influencing the course of forthcoming decisions.

Control of regulatory restructuring is in the hands of the Democrat-controlled Congress. The Democrats have no reason to hurry any discussion along for they are looking at the highly likely scenario of having a Democratic President take office in January 2009 along with larger majorities in both the Senate and the House of Representatives. They are looking at being able to control the debate and dominate the decisions about how the new financial structure is to be designed. The Democrats in Congress have absolutely no reason to show their cards before these changes take place and the elections this fall will not include debates on regulatory issues because of the esoteric nature of the issues and a lack of insight and interest on the part of the electorate.

Yet, changing the regulatory structure of the United States financial system can have very important implications for the future of the country…and for the world. Without knowing what is “in play” in terms of proposed regulatory changes it is impossible to define what these implications might be. The downside is that the new regulatory system could put the United States financial system at a disadvantage relative to the rest of the world so as to harm the ability of American-based financial institutions to compete in world markets. This would be exactly the wrong time for such restrictions to be imposed because of the growth of other financial capitals throughout the global economy, especially with all the wealth accumulating in the Middle East, China, and India.

The fundamental issue of oversight of financial institutions (actually all business institutions) is openness and transparency. In fact, to me, the essence of good management is openness and transparency. Winners are teams that execute better than other teams. Losers are teams that have to rely on secrecy and tricks. Secrecy and tricks are relied upon when you do not have the resources to perform at a high level. Secrecy and tricks can get you by in the short run, but over time the inability to operate efficiently and effectively will catch up with you. Teams that rely on secrecy and tricks, in my book, seldom, if ever, win championships.

The best teams…and organizations…are the ones who do not disguise what they do best, but execute their plans better than anyone else does. In essence, they say, “this is what we are going to do…try and stop us!” These teams…and organizations…play by the rules and are not afraid of full disclosure.

There are two reasons why strong organizations support this kind of approach to management. First, it causes them to focus on what they do well and staff their organizations so as to refine and perfect the execution of their plans as much as possible. This builds strength and confidence in the organization and provides an environment that people who are talented and highly capable want to join. Strength builds on strength as the culture of success grows and prospers. Nothing can substitute for a culture that supports excellence rather than craftiness.

Second, by creating an environment of openness and transparency, the organization identifies weakness, problems, and mistakes as quickly as possible so that appropriate actions can be taken in a timely manner. Effective organizations do not “win” all of the time, but they minimize weak performance and losses so as to sustain an overall record of high achievement. All too often we see organizations that want to shelter poor performance because they kid themselves into believing that it is just a matter of time before “things will turnaround” and “everything will be alright.” As losses mount, they rely on trickery and ‘innovative” accounting to gloss over the real problems and as the hole they are digging becomes deeper and deeper…they fail to stop digging.

There are three specific issues that I am particularly concerned about in terms of openness and transparency. First, I am against “off balance sheet” items. We have seen how major institutions have used this mechanism to bury what they are doing as well as to avoid concerns over capital adequacy. I could never understand why this practice was allowed and, as far as I am concerned, it should be forbidden in the future. If the asset cannot stand the light of being on the balance sheet there are serious questions in my mind about why the organization should be engaged in such activity.

Second, I believe in marking assets to market on a regular basis. Opponents of this disclosure argue that the markets are so volatile that investors would be confused with the constant marking portfolios up and then marking them down on a regular basis. My question to these people is that if an organization has invested in assets that are so volatile…should they be invested in them at all? Have these organizations “stretched” for yield by investing in longer term assets or “high-yield” assets that are not consistent with their charters? If this is the case, then this decision should be revealed to investors in an obvious way and not covered up because, in the short run, the income streams of the institution are relatively constant. Furthermore, for assets that are not traded on markets or are infrequently traded, efforts should be made on a regular basis to determine their value and openly report them. This, not only is good discipline for the management, but it is also important for the investment and regulatory community to know.

Third, some institutions have argued that they cannot reveal what transactions they are involved in because if they did the spreads that they were operating at would go away. I have two comments to make on this concern. If the spreads are so narrow, the organization will probably be very highly leveraged in order to achieve the gains they believe they need to earn and the risk associated with this extreme use of leverage is probably unrecognized by investors. Also, research has shown that everyone seems to know what the transactions are anyway and that is why the spreads are so narrow in the first place. The question that needs to be ask, therefore, is whether or not the risk associated with the transaction is really commensurate with the return that the organization is promising on its operations. Disclosing the nature of these transactions would be helpful to investors in understanding the risks that they are investing in.

Openness and transparency not only can assist regulators and investors, it can also help managements. But, there is one more important point that continually needs to be made to those considering a change in the regulatory structure. “Inflation everywhere and at every time is a monetary phenomenon.” This statement, of course, came from Milton Friedman. Regulation of the financial system is needed, but we must not muddy the waters when it comes to the responsibility of the central bank, the Federal Reserve System. The more oversight and regulation it is responsible for the more its focus becomes blurred. The Fed is already hampered by the responsibility to maintain economic growth as well as to control inflation. As is apparent in the current climate, this is an impossible thing to do. Adding, more and more functions to the Fed can only make its task of keeping inflation at low levels more and more difficult.