Financial Regulation, Prudential Behavior

Last week here, we expressed some concern that not much seemed to be happening with financial regulatory reform, and we thought that issue should be getting more attention. As it turned out, several developments on that front took place in subsequent days. These are important to all of us because in the last two years we've faced considerable danger in all our economic and financial dealings. Now that some of the dust has settled, we need to work at rationalizing the structure of markets and institutions to try to minimize the prospects that crashes and chaos could overtake us again. This work is done mainly through our government officials, but there's a role here for everyone, and we'll will come back to that at the conclusion.

This past week saw three initiatives: the House Financial Services Committee voted out a bill to establish a Consumer Financial Protection Agency, the Treasury and the Federal Reserve both announced rules governing the pay of senior officers of banks and financial firms that have received taxpayer assistance, and the Treasury prepared us for the introduction of new more concrete proposals for general financial regulatory reform.

The CFPA Passes the First Legislative Step
The Consumer Financial Protection Agency would have the power to write consumer protection rules for numerous credit, lending and deposit products and to ban those that it deems "unfair, deceptive or abusive". This authority would be centered on the product or service and not on the kind of institution. The bill gives CFPA authority to examine individual institutions, though, to evaluate their product offerings and practices. This examination would be in addition to any other regulatory examination, such as FDIC or state government bank examinations. A number of specifics have yet to be clearly defined, for instance, how to distinguish car dealer financing, which might be exempt, from financing provided by an auto company's financial affiliate, such as GMAC, which would be covered. The goal is to prevent predatory lending, deceptive practices especially regarding mortgages and to provide clearer information on consumer financial products in general. It has been a high priority of the Obama Administration, who believes that abusive tactics harmed consumers and contributed to the heightened risk that led to the collapse.

Treasury & Fed Come Down Hard on Executive Pay
The second development last week was the announcement of executive compensation caps for financial institutions that have received aid from the federal government and the Federal Reserve. The Treasury Department's "Special Master for TARP Executive Compensation" issued "determinations" on the amounts and forms of payment that can be paid to the five most senior executives and the next 20 most highly paid officers at the seven institutions that received "exceptional assistance" from the Treasury. These firms are AIG, Citigroup, Bank of America, Chrysler, GM, GMAC and Chrysler Financial. The week before, the Special Master, Kenneth Feinberg, had recommended that the out-going chairman of Bank of America Kenneth Lewis receive no compensation at all for 2009; Mr. Lewis agreed to this. Lewis has already announced his resignation from BofA, effective December 31.

The caps limit cash pay for these 175 individuals to $500,000 and any kind of bonus award to restricted shares of stock that cannot be sold for three years. One of the objectives of the action is to shift the executives' viewpoints from short-term, "how can I boost business this quarter or this year", to a longer span that might encompass several cycles of activity or market conditions. Another objective is certainly to limit the liability of taxpayers to these officials whose companies are presently on the government dole.

Almost simultaneously, the Federal Reserve announced a broad initiative to examine compensation policies at two groups of banking institutions, one set of 28 "large, complex" firms and a second broad group of regional, community and other banking organizations. The sense of "examine" here is the technical, legal one applying to the regulatory process. The 28 large, complex firms will have their pay schemes examined all at once, a so-called "horizontal review", so they may be compared with each other at a given point in time. The firms will be told how to modify their pay structures, according to specific principles, and subsequent regular examinations will test for compliance. For the smaller, non-complex institutions, executive compensation will be added to the subject-matter for their regulatory examinations.

Here too, as with the Treasury's edict, a major goal is to lengthen the horizon for executive pay calculation, to shift the focus of the incentive structure over several fiscal periods instead of just "this one", however short that might be. The assumption in both the Fed and the Treasury is that this will help reduce the risk exposure of the firms, since there will be less perceived need to reach for greater risk or to hurry to cram in one more deal this week before the books close on the quarter.

"Living Wills" for Financial Institutions??
Lastly, later today, October 26, the Treasury will submit to the Congress a new plan intended to fix some of the major deficiencies of current regulation. Michael Barr, a Treasury Assistant Secretary testified before the House Judiciary Committee on October 22 to present some of the proposal. It concentrates on "large, inter-connected firms", that is, those widely thought to be "too big to fail". The plan includes new, strengthened capital requirements to undergird their business during downturns and prescriptions for holdings of truly liquid, marketable assets to cover short-term market gyrations. You might recall that during the most chaotic periods last year regular financial business dealings were disrupted when one firm's failure or weakness led to even magnified reactions in other companies and markets. One significant consequence was that government somewhat arbitrarily rescued some firms, but not others, and that only added to the chaos. Now that markets and conditions have settled out some, the Treasury, other officials and other observers – such as my professional economist colleagues who were gathered in St. Louis – want to try to set principles and enforceable rules that will govern such financial rescues. No one, Assistant Secretary Barr should ever conduct business under the presumption that they are "too big to fail". The new program even includes a mandate for specified firms to set up advance directives akin to a "living will" (his term) that set forth a way to shift management responsibilities and the firm's underlying financial structure in the event of some major failure.

Prudential Behavior for Everyone
If you are still with me, Good Reader, by this time you've read about potential fixes for messes arising from badly conceived consumer products and excessive executive pay, and you've read about predetermined ways to relieve management of their duties if their actions in the face of adverse market and business contingencies put their big firm, its associates and its customers, deep in hot water. This is indeed all very messy. We can make arguments both for and against each one of these proposals. Bankers and the Chamber of Commerce argue in one direction; consumer rights organizations in another. Democrats one way, Republicans another. However, we also want to make one more point that takes a step back and looks at these issues from outside. The need for all of them comes because people over-reached or were dishonest or behaved in bad faith or were disrespectful. Much of the trouble came not because consumers were cheated or had fees raised on their accounts, but because they borrowed too much to begin with. Further, other participants in these affairs didn't pay enough attention when there was a lot at stake, they didn't ask questions or they committed lots of their own assets to questionable enterprises or they presumed that their fancy mathematical formula would always work to produce a completely predictable outcome. Some of these people held or hold positions of public trust or quasi-public trust. We all – managers, government officials, consumers – need to be responsible.

Mr. Barr's testimony uses the word "prudential" several times; he wants the new regulations to highlight and encourage prudential behavior. Exactly. Back in February, we talked here about some scandals and we illustrated with the story from the Book of Acts about Ananias. There might be government officials, as well as private citizens, named Ananias. The best remedy for all of this is for all of us to be prudential and take care with our own affairs and treat others with respect. This sounds a bit like the Golden Rule, doesn't it? These are the kinds of issues, it occurs to me, that churches can work on, right with the people in their own pews. Long-term financial fixes can start right there, with a bunch of Christians thinking of themselves and their friends and colleagues in terms of Jesus' lessons.