Filed under: Market matters, Politics, Headline news, Federal Reserve

The last time Washington took a fundamental rethink of how ideal to regulate the financial markets was during the 1930s. Now it’s decided to try again. The New York Times reports that on Monday Treasury Secretary Hank Paulson will announce a plan to substitute an alphabet soup of regulatory agencies with three new ones.

I think it’s a clever way to use the current credit crisis to loosen regulation on the financial industry while doing little to fix the current problem or prevent future ones. A superior way would be to nip future problems in the bud by changing financiers’ incentives — requiring them, rather than taxpayers, to foot the bill for the bad deals they originate — and shedding far more light on their dealings.

Paulson’s proposal brings many questions to mind:

• Would the proposed scheme have prevented the current credit crisis?
• Could the scheme actually be passed by Congress?
• Would it prevent future crises?
• Is there a superior way to manage the capital markets?

I think the answers are no, no, no, and yes. Before addressing these questions, though, let’s analyze what Paulson is proposing. Specifically, he wants to create three new agencies detailed as follows:

• Market stability. This regulator would expand the Fed’s powers — enabling it to send a SWAT team to examine the books and gather other information about any financial institution (FI) it thought was putting the system at risk. This might be a good idea if the Fed had a way to identify and fix the problems of a risky FI before it was too late to do anything about it.
• Prudential financial. This bureau would consolidate the specific agencies that regulate various depository institutions — S&Ls, banks, and credit unions. This isn’t a great name — it’s the same as that of a large insurance company — Prudential Financial (NYSE: PRU) — and the Treasury Secretary must know this. More importantly, by creating a single agency, regulatory costs would be reduced but it’s unclear whether the new agency would achieve greater effectiveness.
• Business conduct. This new bureau would protect consumers from bad conduct from all FIs, subsuming the role of the SEC. If this new agency were staffed with vigilant experts in each of the financial products sold to consumers coupled with massive budgets for investigating consumer fraud, it would be a valuable new service for consumers. But in all likelihood, the FIs would be able to stymie the Business Conduct agency’s effectiveness with their campaign contributions.

I don’t think the proposed scheme would have prevented the current credit crisis. What is this credit crisis? What caused it? I think of the credit crisis as the drying up of bank’s willingness to lend because they have lost trust in other banks’ capability to pay back their loans. I believe this loss of trust resulted from the large volume of complex securities with no market value — e.g., there are $6.1 trillion worth of collateralized debt obligations (CDOs) — on the books of FI’s that borrowed too much money — for example, investment banks and hedge funds borrowed $32 for each dollar of equity.

Paulson’s plan wouldn’t have prevented this problem because it does nothing to change the decisions of the people who take these risks in the first place. Risk management is a form of Quality Control (QC) — a basic principle of which is that the sooner in the process you nip a problem, the less it costs to repair.

As I’ve posted, current incentives reward participants for generating huge volumes of securities and deals. The players enrich themselves by getting a percentage of these volumes as a fee or bonus. If those volumes ultimately prove to be worthless, those players still get to keep their winnings. This scheme encourages financiers to push big deals, regardless of their ultimate profit.

If the government keeps these incentives in place, the players will keep ignoring risk as they invent new ways to get paid the big bucks. And Paulson’s proposal will continue to reward their mistakes by sticking the bill for their failure with the taxpayers — letting the proposed Market Stability bureau clean up moments before the problem is about to reach crisis proportions.

I don’t have a good sense of whether Paulson’s scheme will be passed by Congress. Many members will need to weigh the concerns of their constituents who have suffered from the credit crunch against pressure from the industry — with its campaign contributions — which might favor the looser regulation that Paulson proposes. Furthermore, it is unlikely that much will get done in Congress that does not benefit those running for President. Unless some proposals are seen as benefiting the 2008 combatants, regulatory changes in this area are likely to get deferred until 2009.

And as I posted in October, I think the way to prevent future crises is to change incentives and increase transparency. Specifically, the government should require financiers to put a massive portion of their bonuses in an escrow account. If their deals didn’t “blow up” after a period of time, state eight years, the funds would get paid out of escrow to the bankers. If their deals did blow up, the escrow accounts would be used to pay for their mistakes. Such incentives would make financiers pause before pushing risky, massive deals. If they knew they would have to pay for the ultimate costs, financiers would either reduce the deal risks or not do them.

As for transparency, I would appoint an independent group to assess the value of the future cash flows of asset-backed securities or other risky financial positions such as derivatives. If those cash flows couldn’t be quantified, then the securities would not be traded. If they could be measured, then the values and the underlying assumptions would be made public in real time. This transparency approach would slash the size of the market but keep honest the portion that remained.

This administration has used crises in the past to justify its agenda of tax cuts and reduced regulation on business. For instance, it used the 2001 recession to justify $1.3 trillion worth of tax cuts much of which went to the wealthiest 1% of Americans. Paulson’s proposal is a thinly veiled attempt to use the current credit crisis to slash regulation on financial institutions without addressing its real cause.

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter. He has no financial interest in the securities mentioned.

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