Financial Regulation Pitfalls

Governments worldwide have sought to establish tougher regulations for the financial industry to prevent future global economic crises. In the United States, the Federal Reserve and the Treasury recently set forth guidelines to curb excessive banker pay, while the U.S. Congress continues to debate how to regulate derivatives, risky consumer financial products, and financial firms considered "too big to fail." CFR Senior Fellow Marc Levinson warns that some of the proposed regulatory fixes, such as "living wills," may seem plausible in theory but won’t be practical when another crisis is actually in play. He says international coordination wouldn’t necessarily help promote financial stability and that past international agreements incentivized banks to take more risk by moving assets off their balance sheets. He also says that efforts to curb banker pay or tie it to company performance aren’t likely to be effective, since companies have proven to be skilled at "gaming" the system.

Critics have contended that banker pay guidelines unveiled by the Federal Reserve last week may be giving banks too much leeway. What’s your view?

Having given a lot of money to these organizations, the federal government is justified in getting involved in compensation. The problem is that controlling compensation may not be the best way to protect the taxpayers’ interests. There’s a lot of political pressure to limit compensation, but the government now should want to maximize these companies’ profits, because that’s the only way taxpayers are going to get paid back.  If controlling compensation causes key people to leave these companies and hurts profitability, that’s going to be bad news for taxpayers. People may feel better having gotten some revenge, but that’s not going to be a good outcome for the institutions, so the government needs to tread carefully in this area. That said, there’s clearly a political need to do something here, and one can argue that at some financial institutions, compensation practices were not structured in a sound way.

What kind of impact or enforceability would these Fed guidelines have?

With respect to the banks, federal guidelines are quite enforceable.  The question is: how can the guidelines be gamed? So far, we’ve found that companies are pretty good at gaming pay rules. It was decided a few years ago that giving stock grants to executives was a bad idea because that gave them an incentive to drive up the stock price in the short term, so many companies moved to stock option grants.  It turns out that stock option grants weren’t necessarily a long-term incentive either. It’s actually very hard to devise compensation systems that work in the long-term interests of shareholders, and of financial stability generally. The Fed is going to have to spend a lot of time monitoring this. Realistically, control has to come from shareholders, not from the federal government.

For many people in the financial industry, including some of the highest paid people, what they have made is directly related to what they have earned. I’m not talking about executives here; I’m talking about traders, for example. Traders on Wall Street have a profit and loss every day. Some of them make mega-bucks, some of them don’t make much at all. It really depends on their own personal performance.  So it’s really very hard to make statements about these people being overpaid or underpaid because if they don’t perform well they don’t get paid well.

Federal Reserve Vice Chairman Donald Kohn recently said that the reform of the financial industry shouldn’t be rushed because there is a need for international coordination. Is international coordination necessary and would it be effective?

We have a long history of international coordination in financial regulation that goes back to the 1970’s.  The net result in some areas has been very positive. In other areas, it really hasn’t been so good. There has been a lot of progress made on international coordination on regulating the plumbing of the financial system -- things like clearing and settlement, to make sure transactions get recorded properly, that money gets moved from one place to another properly, that collateral gets recorded properly. On the other hand, we’ve had cooperation now for years trying to set financial guidelines for banks in order to protect the stability of the world financial system. Those guidelines focused exclusively on bank capital. One of the things that we discovered during the recent crisis is that bank capital should not have been the only concern.  For example, many banks seemed to be adequately capitalized, but they couldn’t raise cash to open their doors. So their problems were liquidity problems rather than capital problems. The internationally agreed regulations don’t say anything about this, and that’s going to be one issue going forward.

All the major countries have focused entirely on capital. Very few of them have focused on liquidity. Many of them have not focused as much as they should have on the leverage in the banking system.  It’s also obvious that some of these agreements had unanticipated and undesired side-effects.  For example, the agreements focused on the capital that the financial institutions had relative to the assets on their books. This gave the financial institutions a big incentive to move the assets off their books, because if they didn’t hold the assets, they didn’t need to hold capital against them, and capital is expensive.  One of the reasons we saw such rapid growth in securitization is that the financial institutions basically had a financial incentive to get these loans off their books, and this also was arguably the result of this international collaboration. So in some cases I would argue that the international collaboration proved, if not counterproductive, certainly ineffective.

Central banks are pushing different proposals on regulating financial institutions that are "too big to fail." Federal Reserve Chairman Ben Bernanke has suggested "living wills" that would make it easy to dissect financial institutions that become insolvent.  How effective would these regulations be in staving off another financial crisis?

If this was a simple issue to tackle, it would have been tackled. Some of what is coming out here is just not practical. To the question of "too big to fail," we’re not likely to break up the institutions directly. There is going to be a lot of pressure to restrain certain types of activities, of which the most obvious is what’s called "proprietary trading." This is basically the banks trading for their own accounts, trading for their own profit, not for their customers. There is a pretty good argument that the banks have an unfair advantage in this area when they’re backstopped by the government when other people are not backstopped by the government. It would be relatively simple to restrict bank activities in this area.

There’s much discussion about these so-called "living wills." I’m not persuaded that they have any credibility. Part of my concern here is that things that seem good at a moment when the crisis has passed may not be viable when there is actually another crisis.  For example, there is a lot of interest in the idea of requiring banks to have a new sort of security. This would be a bond, but it would automatically convert to stock under certain conditions. The idea here is that if its financial condition became serious, the bank’s equity capital would automatically increase while its required interest payments would decrease, because these bonds would convert to stocks. This is now being promoted as one idea for making banks more stable. But think about what happens when a bank actually announces that such bonds have been converted into stock. What is the market going to make of that?  The market is going to say, "I don’t want to do any more business with these folks."  This is one of those things that makes a great deal of sense on an economist’s blackboard, but perhaps not in the real world of messy markets.

Some derivatives users have lobbied against having their transactions go through a regulated exchange. What’s the risk of allowing exemptions?

There are risks for the users, and there are risks for the system. The risk for the users is that it is very difficult to know the financial health of your counterparty. If the contract is traded on an exchange, the user’s financial obligation is to the exchange, and the exchange sets requirements so that the users have a very high probability of getting paid what they’re owed. If you’re dealing with a private party you don’t necessarily know that, and you may not have adequate information about the party’s other derivatives dealings, so you don’t really know if the private party has the financial strength to meet its obligations to you.  Systemically, much the same issue arises because many financial institutions may have very large derivatives books, and it’s very hard for the regulators to keep an eye on them. In some cases, these books are being run by institutions that are not even government regulated. And there may be enough money at risk at one of those institutions that it causes more general problems through the financial system. So it’s desirable to keep the exemptions to a minimum.