Tips for a New Regulatory Structure

Since the candidates are making such a fuss about all these recent issues, and especially calling for more regulation, here are some helpful hints to ensure we all benefit…

1. Organize your regulatory structure like financial institutions organize their businesses. For example, instead of the C.F.T.C., M.S.R.B., N.A.S.D., and exchanges all regulating various parts of the financial infrastructure, build an overarching financial regulatory agency (you can even call it that, the F.R.A., I won’t charge you a quarter to use it each time). Have a division for banks and a division for broker dealers. In the division for broker dealers have the departments that oversee mergers and acquisitions, issuance of debt and equity, and trading in distinct units. Then, within each, subdivide it further–futures trading, exchanges, fixed income trading, etc. This is how firms organize their businesses. When a transaction crosses multiple areas, in the same way an investment bank would bring in multiple people “up the food chain” regulators can mimic that same structure and bring in people with similiar experience and oversight responsibilities.

A part of this is to merge banking oversight with broker-dealer oversight. This is because soon there will be no more standalone broker dealers… Ok, I’m kind of kidding… or am I? Another reason for this change is that, the same way large firms unite their operations and inter-weave their market activities, banks and broker dealers have become much more inter-connected. Let’s be honest, the average bank is less likely to be stable if it has a broker dealer that is massively leveraged and buying risky securities. Need an example? How about looking at Citi vs. J.P. Morgan Chase? Or E*Trade bank versus Commerce Bank?

2. Don’t let financial institutions lobby. Simple, right? Hank Paulson immediately put his boot on the throat of the Fannie and Freddy lobbying machine when bailing them out. Simple! With all the terrible things being said about lobbysists this cycle, you wouldn’t know politicians were running–so I’m sure there will be support for this kind of reform. Also, all things being equal, the average American is left worse off by lobbyists (hence the “reform” candidates all rail against lobbyists). Sadly, even the institutions the lobbysist were lobbying on behalf of seem to be in a situation where they would be better off had they not gotten what their lobbyists were lobbying for… Whew!

However, it must be difficult for a congressman to pass a law stopping a corporation from lobbying. It might even be illegal… not sure, I’m no lawyer. What I do know, however, is that if the governement decides to have their resources used to facilitate business for institutions, one could probably make the cessation of lobbying a condition. Would you rather put your money in an F.D.I.C. insured bank? Would you rather your bank could borrow at the discount window? Special tax breaks for profitable business lines? All these things should require the institution in question doesn’t lobby for, say, five years. I bet banks can get themselves into trouble often enough that, if they ask for help each time, a five year cessation of lobbying or hiring lobbyists will mean no more lobbying. Want to increase your leverage by borrowing freely from any of the Fed’s various sources of money? No lobbying.

3. Increase capital requirements for financial institutions. Make very strict rules for what counts as capital and how regulated ratios are determined. For example, perhaps holding Goodwill against sub-prime–backed C.D.O. squared’s isn’t the way to go. Or, maybe, allowing banks to book earnings from their credit deteriorating isn’t the way to go either. Suggesting that capital be better defined and more plentiful shouldn’t be a shock… this crisis of capital, with institutions begging investors to buy equity, is an issue with banks, capitalized as required, not having enough capital and failing (banks being used broadly). Lowering leverage lowers raises the economic margin of error. While lots of people will argue that an over-levered instution that invests in risky securities deserves to fail, why not avoid the over-levered institution that invests in risky securities in the first place? Actually, stop listening to me… Instead, for this, listen to The Deal Professor:

Lesson 4: Sometimes, You Can Only Raise Capital When You Don’t Need It

Lehman issued $4 billion in preferred stock in April — the share offering was oversubscribed. Even then, though, people whispered that the capital raise was a sign of weakness, reflecting Lehman’s anemic balance sheet. This paradox helped bring about the death of both Bear and Lehman: They needed capital, but raising it only made people more concerned about their state.

It is a Catch-22 for which we have yet to find a solution. And that is why, even to the bitter end, Lehman didn’t access the Federal Reserve’s emergency loan facility. If it had, everyone would have assumed it was in trouble.

The whole conundrum supports raising the capital reserve levels for investment banks. Ultimately, Lehman, Bear, Merrill and their balance sheets couldn’t stand the predicament

(Emphasis mine.)

See? Much more eloquent than I was…

4. Disclosure. One simple word. Require a lot more disclosure. How about setting well-defined scenarios that must appear and be spelled out in annual and quarterly filings? Report more sensitivities, using standard methods that are also disclosed, of assets to model parameters or market changes. If, for example, each investment bank was required to tell investors how their balance sheet would look if defaults ticked up to “5 CDR for life” there would be a lot less trouble today.

Also, force diclosures to occur more frequently. Make banks release some key metrics every Friday, for example. Having a 45-day delayed disclosure that is a snapshot from the last day of a 90-day period is completely ridiculous. We have computers now. One needen’t get out their abacus and punch cards to figure out earnings for a given period. Stop “month-end” dressing up of the balance sheet by requiring more frequent disclosure. Require banks to disclose maximums from the past x days. This way, if a bank tries to shrink it’s balance sheet purely to look like it’s done so, so that it can diclose soemthing that “looks better,” it will show up. Hiding information from shareholders or whomever else reads filings is not just troublesome, it shouldn’t be allowed.

These are just some of my random thoughts. I’m not sure they have merit, except where they are quoted from others. I’m no regulator, but if the next president needs and S.E.C. chairman, I suppose I can make myself available…

Explore posts in the same categories: Assets, Equities, Finance, Financial Institutions, Information, Networks, Platforms, Risk, Structure, Systems

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2 Comments on “Tips for a New Regulatory Structure”

  1. […] * Dear John Thain has some ideas for a new regulatory structure. […]

  2. euandus Says:

    Consider the presumptuousness in the banking lobby involving itself and insisting that its interests be served in Congress as it fashions financial regulatory reform. That they are in any position to be part of that process is beyond at least John Galbraith. If you are interested, here is my post:

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