Where’s the Plan, Wall Street?

For the last several months, Americans have looked to Washington to lead them. But where’s the leadership on Wall Street?

There is an enormous opportunity for a CEO to come forward with a plan to reform the financial system and pledge a change from business as usual. Jamie Dimon, JPMorgan Chase’s chief executive, has been the most outspoken of his peers during the crisis—and has done an admirable job addressing the issues—but he has been more focused on helping instill confidence in the economy and the health of his own firm. John Mack, the chief executive of Morgan Stanley, has shown glimpses of public leadership, at one point apologizing for the crisis by saying, “We are sorry for it.”

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AP

But the public could particularly benefit today from a forceful voice of reason and change within the industry, proposing how to remake the world of finance in a sensible way, driven not by populism but by practicality and a sense of fairness.

It’s worth noting that most Wall Street CEO’s are being advised by their legal and public relations teams to keep their heads down or risk provoking more public outrage. But there is the flip side to that coin: reasoned leadership may generate a reasonable response, helping the industry pre-empt what it fears most—additional government regulation.

So in that spirit, here’s a five-point plan to refashion Wall Street. A plan that would be best sold by Wall Street itself.

Glass-Steagall 2.0

It may seem like a bitter pill to swallow, but a Wall Street CEO should be taking part in the discussions about whether to restore the Glass-Steagall Act, which, until its repeal a decade ago, imposed a wall between commercial banks and investment banks. It’s an idea that Paul A. Volcker, the former Federal Reserve chairman who leads President Obama’s Economic Recovery Advisory Board, raised last week at New York University.

“Maybe we ought to have a kind of two-tier financial system,” he suggested, according to Bloomberg News. “What used to be the traditional investment banks, Morgan Stanley, Goldman Sachs, so forth, which used to do some underwriting and mergers and acquisitions, are dominated by other activities we would exclude—very heavy proprietary trading, hedge funds.”

Bringing back Glass-Steagall may not be the most popular idea in financial circles, but the debate is already under way. Agreeing to some limits on the kinds of activities that banks and other businesses participate in could go a long way toward ensuring that no institution is too big—or too interconnected—to fail.

Traditional banks don’t need to be barred from underwriting and trading, but when people talk about how AIG ran an in-house casino, it’s not the wrong analogy—for the insurer and, frankly, for many banks. And casino losses can clearly infect the rest of a business. Either there needs to be a massive firewall erected to contain the potential damage, or some institutions may need to rethink the businesses they are in.

A COUNTERCYCLICAL APPROACH

All banks are required to maintain a certain capital ratio during good times and bad. But we’ve never made a distinction between the two environments. Sheila Bair, chairwoman of the FDIC, raised the issue, as have others, of adjusting those capital requirements depending on the cycle. At a Congressional hearing last week, she suggested that “financial institutions could be required to limit dividends in profitable times to build capital above regulatory minimums” against future losses.

That would have helped troubled institutions ride out the downturn without taxpayer help, she said. Such a standard wouldn’t be popular with banks’ shareholders, who could see their dividends capped, but it would be a hit with taxpayers—who are shareholders, too, at least for now.

Mending Mark-to-Market

A number of financial executives, led by Stephen A. Schwarzman of Blackstone Group, have been pressing for the removal of mark-to-market accounting standards, which they say amplify potential losses and destabilize the system. As an accounting standard, mark-to-market has strengths and weaknesses. It creates an enormous amount of transparency by forcing institutions to mark their assets’ value to whatever they are worth on the open market, rather than to their cost, or to what an in-house model says, which some deride as “mark-to-make-believe.”

Where the system falls short is when there’s no market at all, like now.

Banks have been forced to take huge “theoretical” write-downs because of mark-to-market, but to maintain their capital base they have had to raise real money. There has to be a middle ground, and it probably revolves around disclosure.

Perhaps capital requirements could be eased—as part of a countercyclical capital standards program—so that markdowns don’t send a firm into a tailspin. In exchange, though, financial institutions would show shareholders, on a granular level, the marked-down assets and how they are valued. Many banks are holding on to their assets because they believe they’re worth more than the market will bear. If that’s true, they should open up their kimono and show everybody—maybe the market will agree with them.

Credit Default Swaps

One of the most important markets that may have to be reformed is the market for credit default swaps—those insurance plans that investors can buy to protect themselves from an institution’s defaulting. There’s good reason for the insurance to exist: If you are a client of a firm or own its debt, swaps are a smart way to make sure you are left with something if the firm collapses. But investors are allowed to buy swap protection even if they have no exposure to the firm. That means they are not buying the insurance to protect themselves, but rather as a speculative bet. In this case, it’s the equivalent of buying insurance on someone else’s house.

And that’s a problem. It creates an incentive to burn that person’s house down, or even whisper that it is practically a tinderbox. We have seen how quickly the erosion in confidence in a bank can turn fatal. So there needs to be a requirement that investors who buys credit default swaps have provable exposure to the underlying security that they are insuring, in the same way that you’d have to prove that you own a home before buying insurance for it.

George Soros, the prominent financier, has been an advocate for fixing this market. “The sheer existence of an unregulated market of this size has been a major factor in increasing risk throughout the entire financial system,” he told a House committee in November.

Compensation

Wall Street’s pay structure has become the biggest occasion for national ridicule, and rage, and understandably so. There’s a built-in imbalance. In good years, top employees share in huge riches. In truly dreadful years, like last year, there are still bonuses across the firm—just smaller ones.

There are going to have to be changes, starting with the bonus numbers being a lot smaller, even in good times. Wall Street chiefs need to recognize this new reality and step forward with their own set of solutions.

One fix, which some firms have already begun to explore, would expand the time frame for evaluating bonuses from one year to several years.

If employees knew that their pay depended on profits that were sustainable, not the kind that could blow up 12 months down the road, they would have greater motivation to weigh the risks along with the rewards.

Since few firms lose money for years in a row—and if they do, they should be asking serious questions about who’s in charge—this wider window could cut down on the awkward situation in which a firm awards bonuses for a period when it didn’t make a profit.

And it could help soothe seething shareholders—and taxpayers.