The Regulatory Revolution Is Nigh
To: Treasury Secretary [Dimon, Buffett, Paulson, etc.]
From: The Deal Professor
Date: After Nov. 4
Congratulations on your confirmation as Treasury Secretary, a position which [your predecessor/you] elevated to the level of ruler of the United States financial markets. No doubt these are troubling times, but they are also an opportunity to reshape the regulatory playing field in a way that has not happened since the Great Depression. When Alan Greenspan himself stated that he “made a mistake” in assuming that government oversight was unnecessary and that the free markets could be trusted, it put the nail in the deregulatory coffin.
But make no mistake, while you may rule the financial markets, Congress is now bent on erecting its own regulatory regime. Political interests will vie for their own personal agendas. Your job will be to guide the new administration through this minefield and erect regulation that is not only sensible but as flexible and enduring as that which was created more than 75 years ago.
As you do so, I offer a few principles that may guide you.
1. Regulate to the New Paradigm
The problem with Congressional financial regulation is that it often regulates to the last scandal/market disruption. There will no doubt be regulation of the banking and financial industry (more on that below), but you need to focus on where the financial markets are going rather than what they were.
We have witnessed the extraordinary demise of the traditional investment bank model, the creation of giant “too big to fail” bank holding companies, the rise of mid-tier investment banks and the omnipresent nature of wounded but still surviving hedge funds. In the future, much of the innovative capital creation and trading is likely to move from the Goldman Sachses of the world to the hedge funds and alternative financial institutions.
Moreover, the mid-tier investment banks, the Greenhills of the world, are likely to profit greatly as they move to occupy the roles left open by the now-defunct Big Five investment banks. And don’t forget the private equity firms: Blackstone Group and Kohlberg Kravis Roberts were already moving to an investment banking model, and the crisis will only accelerate this process.
Any regulatory solution needs to take into account these actors, the new markets they may create and future financial innovation. This means creating regulation that logically applies to all situations and parties. For example, hedge funds likely should be subject to leverage and disclosure regulations as well as other financial institutions with adjustment for their own particular circumstances.
And any regulation of the new bank holding companies will likely only drive these markets abroad or to these new actors. You not only need to regulate holistically in the United States but coordinate any response with Europe and Asia.
2. Regulate to Prevent Political Bias
You are about to be in the middle of the mother of all regulatory power grabs. The government will undertake needed regulatory agency consolidation, but the likely victims — the Commodity Futures Trading Commission, the Office of the Comptroller of Currency and others — will fight for their lives. Meanwhile, the real action will be who gets the new powers of systemic regulation.
In other words, who will regulate the coming leverage and other capital requirements for financial institutions and other actors? The Federal Reserve will no doubt want this role, as will your own agency.
The Fed is its own opaque and separate beast, while Treasury is a political agency. A government agency is likely to get tremendous power to cure future systemic crises. Think hard about whether this type of regulation belongs and should be insulated in a governmental agency, whether it be a new one or a reformed Securities and Exchange Commission.
3. Regulate to Align Risk with Reward
There were two important failures here. The derivatives market allowed the separation of ownership from risk. Banks, knowing that they no longer had to worry about loans being paid back, became concerned only about whether these loans could be securitized and sold.
You need to erect a system that ensures institutions keep skin in the game. Whether it is requiring them to retain an ownership interest in the securities they sell or disallowing ownership of some derivatives such as credit default swaps without ownership of the underlying asset, this should be your goal. The free market needs to work here and government regulation can only go so far; requiring an ownership element is one way to do it.
- Forget About Staying on the Sidelines
- Cramer Explains Market's Wild Fluctuations
- Market Psychologist: Cooler Heads Must Prevail
- 'Sell and Get Out of the Way'
- Why Emerging Markets Are Caught in Crisis
- Crescenzi: The Big Questions Now
- Credit Spreads and Libor Data
Moreover, you need to climb into the rabbit hole of executive compensation. At these regulated institutions, you need to ensure that executives cannot profit from short-term gains at the expense of longer-term shareholders and taxpayers. I do not envy you on this task, as Congress in the bailout plan has shown they are incapable of setting such standards.
Still they are needed. Act prudently and intelligently to mold these standards in a regulatory entity and focus on real clawbacks, not the weak type we saw in the Sarbanes-Oxley Act.
4. Do Not Let the S.E.C. Wither
The S.E.C. has become a punching bag for Congress. But remember, the S.E.C. did try and regulate hedge funds. It was otherwise limited by prior presidential administrations, and, in any event, the law did not allow for direct, comprehensive regulation of the investment banks. Bank and systemic regulation was largely without their purview.
The S.E.C. may indeed absorb the C.F.T.C. but do not let the S.E.C. become a mere consumer protection agency, as I suspect it may under any regulatory reform. Rather, reinvigorate it. Force the appointment of an energetic reformer and build it into a market regulator with real systemic powers over the financial markets (see point 1 above). The S.E.C. can do this — it needs to be given the chance to rise to the occasion.
5. Disclosure Matters, and Beware of Over-Regulation
Enhance the disclosure requirements put on financial community participants, from hedge funds to private equity to banks. Even if this is not allowable, provide for an auditing function for each of these. The S.E.C. has made a hash of disclosure and allowed issuers to get away with too much — this is simply enforcing the current laws on the books.
Meanwhile, beware substantive regulation like preclearance of derivatives. This is likely to have perverse effects and pit the government against clever financiers in a race the government is bound to lose or drive financial business overseas. Again, disclosure is probably the best first principle in many cases.
Otherwise, fight for legislative grants of authority that allow any regulation to be implemented by agencies who can assess the impact and economics of these new rules. Allowing Congress to write the standards rather than empowering regulators to do so will result in half-baked political agendas being implemented.
6. Credit Ratings Agencies
A system needs to be built that holds these agencies accountable. The whole circularity of ratings agencies cutting Lehman Brothers, etc., because of stock-price declines, creating a self-fulfilling downward spin, exposes the ridiculousness of some of their conduct.
7. Think 50 Years Ahead
You have an opportunity to remake the regulatory system and the U.S. economy in a manner that no one other than Alexander Hamilton has. Congress will try and set its own agenda, but you should and have the power to steer it in the direction of these principles if you act correctly and create confidence. Be worthy — and see point number 1.
Steven M. Davidoff, writing as The Deal Professor, is a commentator for DealBook on the legal aspects of mergers, private equity and corporate governance. A former corporate attorney at Shearman & Sterling, he is a professor at the University of Connecticut School of Law. His columns are available at The Deal Professor blog.