Sunday, October 25, 2009

Six Steps to Revitalize the Financial System

Six Steps to Revitalize the Financial System. By SANFORD I. WEILL, former chairman and CEO of Citigroup, AND JUDAH S. KRAUSHAAR, managing partner of Roaring Brook Capital
We need one regulator that can see a company's entire balance sheet. Pay caps will only drive talent abroad.
WSJ, Oct 26, 2009

The debate over financial services reform has meandered for weeks without a clear sense of urgency. It would be a huge opportunity lost if our political, regulatory and business leaders cannot craft a credible new regulatory foundation for one of America's pre-eminent industries. It's time to set politics and regulatory infighting aside and establish the new rules of the road for this critically important business.

Several principles should guide reform. Our country needs to strive for transparency in financial-company balance sheets and recognize the direct correlation between clarity in asset value and how financial enterprises are valued by investors. Mark-to-market based accounting must be revitalized, and complex instruments and securities must be subject to regular market-valuation tests whenever possible.

To accomplish this, a single regulator needs to be tasked with overseeing systemic risks and must be empowered to monitor risks in all sorts of financial institutions. There should be no more balkanization of regulation.

At the same time, regulators and industry leaders must come together and develop workable arrangements whereby innovation in financial services can once again flourish. We need to agree upon new capital requirements and rules for how the securitization market will operate. All parties need to operate with dispatch because the revitalization of the U.S. economy is what's at stake.

One thing our public officials should not do is get caught up in a debate over "too big to fail." It's a catchy phrase, but that's about it. Indeed, it is important to recognize that our recent financial crisis was provoked by last year's failure of Lehman Brothers, a company that few, if anyone, would have argued was too big to fail. Rather than get side-tracked on this and other complex questions, our policy leaders should focus directly on how to create and enhance market discipline.

We have six specific recommendations for reforming the financial services business:

1) Make the Federal Reserve the super-regulator responsible for overseeing systemic risk. It is vital that one regulator be able to see the entire balance sheet of the country's largest financial institutions, and this regulator needs to cut across artificial institutional lines. Large banks, securities firms, insurers and hedge funds should all come under the Fed's aegis. Anything less risks a perpetuation of regulatory arbitrage, where industry participants house their riskiest activities in the unit overseen by the most lenient regulator.

Other regulators would continue to focus on their respective industry segments exclusive of the largest, most complex institutions. Policy makers should avoid creating new bureaucracies, as some have recommended. Existing regulatory bodies should be given a broader charge to oversee consumer protection for credit-related products.

2) As much as possible, complex instruments should be subject to regular market valuation tests and clear through a central clearing house. We need a system that encourages valuations to be based on real markets and not on "mark-to-model." These last 18 months have demonstrated to us all that models work until they don't work. For underwritten offerings, a financial institution must be able to find a real public market value or the transaction should not be done. Derivatives with standardized features should be subject to daily valuation marks, and owners of these instruments should be required to maintain a reasonable amount of equity to support the position (i.e., akin to the traditional margin requirement on other securities).

For highly customized products and newer instruments that might not yet be mature enough to enjoy a large and deep market, we would allow an exemption to encourage innovation. Nonetheless, these exemptions should be regularly reviewed with regulators who should establish disclosure and trading rules that would promote maximum transparency or a means of public market price discovery. Lastly, everyone should apply the basic principle that if you don't understand something, you probably shouldn't be doing it in the first place.

3) Reform and revitalize the securitization market. Though the securitization process has been given a black eye over the past couple of years, it is important to recall that this market adds value by allowing issuers and investors to efficiently match risk, return and duration preferences. While portions of the market were abused, it is important that the baby not be thrown out with the bathwater. In the future, issuers should be required to retain on their balance sheets a substantial portion of the securitization and should be required to periodically test for current market values by selling into the market a portion of their holdings. In this fashion, both the issuing institution and the investors who bought the securitized asset would value the same asset equally.

4) The regulators need to engage the rating agencies. Going forward, the rating agencies should develop clearer standards for rating complex securities. The integrity of principal must be paramount whenever a security is given an investment grade rating. Moreover, the activities of the rating agencies should be subject to an annual review by the systemic regulator (i.e., the Federal Reserve), which in turn should publicly report issues that might compromise the safety and soundness of the country's largest financial institutions.

5) Capital requirements and reserve policies need to be overhauled. While excess leverage and imploding asset values provoked the recent crisis, pro-cyclical loan-loss reserve methodologies aggravated the situation. This has been particularly true in consumer credit where the Securities and Exchange Commission in recent years has forced banks to lower reserves as delinquencies have declined and reverse course when problems moved higher. This sort of regime seems foolhardy. Formulas work no better than mark to model.

To address the matter, financial companies should be encouraged (or perhaps required) to securitize credit wherever possible and carry the instruments at current market value. The greater the transparency in asset valuation, the better. For instruments that may not lend themselves to securitization, such as business loans with highly customized terms, the financial institutions should be allowed—in close coordination with the regulators—to set forward-looking reserves that would smooth earnings (and confidence) during periods of credit stress. Assuming an increased percentage of large financial institutions' assets could be subject to market-value accounting, earnings volatility might increase, but improved transparency would be a net positive for how these institutions would be valued. Of course, higher regulatory capital requirements could go a long way toward dampening earnings volatility; and we'd favor a relatively simple and conservative definition for regulatory capital, namely focusing on tangible common equity as a percentage of assets.

6) Align executive compensation with long-term returns. Policy makers need to move past polemics and recognize the importance of fostering loyal and motivated employees in the financial services business. Knee-jerk caps on pay will only drive talented human capital to foreign companies and erode the traditional leadership of U.S. financial institutions. We recommend a system in which equity-based pay and cash compensation be vested over a relatively long period.

The cash portion should be allowed to increase or decrease in value over the vesting period at a rate consistent with the company's return on equity. In this manner, employees would not be allowed to benefit from inherently short-term results, and risk-taking within institutions would be better controlled.

U.S. financial markets are at a unique moment in history. Without comprehensive and thoughtful reform, American leadership in global finance could be compromised, and lingering uncertainty regarding the "rules of the road" could undermine economic recovery and growth. To restore confidence, U.S. policy makers need to create a muscular super-regulator and promote market-based valuations for financial company balance sheets. Such a program would send a powerful message of transparency and integrity to the markets.

Mr. Weill is former chairman and CEO of Citigroup. Mr. Kraushaar is managing partner of Roaring Brook Capital.