A Critique of the President’s Financial Regulation Reforms

Posted by Richard A. Posner, Circuit Judge, U.S. Court of Appeals for the Seventh Circuit; University of Chicago Law School, on Thursday August 27, 2009 at 9:51 am
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(Editor’s Note: This post by Richard A. Posner is the second part of a two-part series, and is based on a recent article in Lombard Street; the first part was posted on the Forum here.)

If the proposals in the Obama Administration’s report on financial regulatory reform are adopted, the restriction on the size or form of executive compensation on Tier 1 Financial Holding Companies (FHCs) may be the one that most alarms financial enterprises. Let me turn to that issue.

We should separate issues of compensation of CEOs and other top management from issues concerning the compensation of traders, loan officers, and other financial executives at the operating rather than the management level. The Federal Reserve would be authorized to regulate compensation at both levels, but at the top level the aim would be to make management a more faithful agent of the shareholders, while at the operating level it would be to curb the risk‐taking incentives of financial executives by requiring that much of their compensation be deferred. The deferred component might consist of restricted stock that could not be sold for a period of years. Or the deferred component might consist of cash bonuses that could be recovered by the company if the deals for which the bonuses were a reward later soured.

The two aims—better aligning executives’ incentives with those of the shareholders, and reducing the riskiness of executives’ compensation—are inconsistent. Shareholders are generally less risk averse than executives because they have less stake in the enterprise, as they can diversify away any risk that is peculiar to the enterprise by holding a diversified portfolio of securities. Top executives have much more to lose, in reputation and future earnings prospects, from the collapse of their company.

That means that top executives, provided that they are allowed by the Federal Reserve to remain imperfect agents of the shareholders, have strong incentives to establish procedures that will prevent traders, loan officers, and other subordinate executives from taking excessive risks. But “excessive” from the standpoint of private businessmen means something crucially different from “excessive” as perceived by the Federal Reserve. Risks, including the risk of bankruptcy, that are cost‐justified from a corporation’s standpoint may be unacceptable from a broader social standpoint because of their potential for bringing down the entire financial system, and in its wake the nonfinancial economy as well. But the measures that have been suggested for reducing risk‐taking by traders and other financial executives have their own problems. Many things can affect a stock’s price besides a trader’s deals, as critics of stock options as devices for compensating top executives point out, and retractable cash bonuses (would they have to be placed in escrow?) make it difficult for recipients to manage their finances.

Lucian Bebchuk, the Harvard professor of law and economics who is the leading critic of existing corporate compensation practices, does not advise that the government restrict the compensation of executives at the operating rather than managerial level, even in financial firms that might be eligible for classification as Tier 1 FHCs. Rather, he would have the Fed impose penalties for taking risks that can endanger the entire financial system on just the top executives, on the theory that this would motivate them to restrict the risktaking activity of their subordinates. For example, the Fed might require the CEO of a Tier 1 FHC to place two‐thirds of his salary and bonus in escrow, from which he could withdraw the money only after five years. This would motivate him to establish and enforce procedures that would reduce the likelihood that a deal or deals made anywhere in the company would blow up and destroy it and by doing so perhaps create the kind of chain‐reaction effect that I illustrated with the example of Lehman Brothers (for my analysis of Lehman, see Part 1).

This is an ingenious suggestion, greatly superior to the Obama Report’s recommendation to loose the modestly paid civil servants of the Federal Reserve on the entire compensation structure of Tier 1 FHCs. But it has drawbacks, mainly the fact that regulators lack the expertise required to establish compensation procedures that will balance a firm’s competitive needs against the macroeconomic risks that rewarding risky financial decisions can create. Errors by the regulators will create openings for non‐Tier 1 FHCs, including foreign firms that may be identical to Tier 1 FHCs in all but regulator‐imposed constraints, to skim the cream of the Tier 1 FHCs’ financial executives. U.S. firms that escape the classification may be able to do the same thing: eat the Tier 1 FHCs’ lunch by avoiding the heavy hand of regulation.

The most questionable proposals in the Report concern the protection of investors and consumers from false, misleading, or “unfair” practices by the banking industry (as always, broadly construed to include the “shadow banking” industry, consisting of financial intermediaries that provide services similar to banking) and the credit‐rating agencies. I shall discuss three of the proposals: that originators of mortgage‐backed securities and other securitized debt be required to retain a minimum five percent interest in the securities that they sell; that oversight of credit‐rating agencies be increased; and that a new agency be established, the Consumer Financial Protection Agency, to protect consumers from making mistaken or foolish decisions regarding taking on debt, such as credit‐card or mortgage debt.

The premise of all three proposals is that the financial and broader economic crisis in which the nation finds itself is due mainly on the one hand to the irrationality and sharp practices of bankers and on the other to the irrationality and gullibility of their customers. The bankers are fools and knaves and consumers are fools. This is, to put it mildly, an oversimplification. The disaster is more plausibly attributed to regulatory errors, as I have explained in Part I. But since the Report advocates more regulation, it is unsurprising that it should downplay—to the extent virtually of ignoring—the regulatory errors that are the main underlying causes of the disaster.

Especially implausible is the idea that sophisticated investors were gulled. The specific premise of the proposal that the originators of securitized debt be required to retain an interest in the securities when they sell them is that the requirement will make them less likely to sell securities that they know to be worth less than the selling price. Now it is true that the seller of a product usually knows more about its possible flaws than the buyer, that a security that consists of a package of thousands of mortgages is as a practical matter impossible for the buyer to inspect, and that the seller’s retaining “skin in the game” is a conventional method of reducing the risk to the buyer that the product may be defective; in effect, the seller is giving the buyer a hostage—the seller’s interest will die if the product explodes.

But all this is well known to the banks, pension funds, sovereign wealth funds, and other buyers of interests in mortgage‐backed and similar securities. These interests (“tranches,” as they are called) are not marketed to or bought by consumers. They are sold to sophisticated investors. If those investors want the sellers to retain “skin in the game” as a guarantor of the quality of the product, they can negotiate for such a provision in the contract of sale—as some did. None of them needs the government’s protection, as is further shown by the fact that banks that originated securitized debt also often bought interests in such debt from other originators, something they would not have done had they been skeptical about the value of such securities, as they would have been if they were deceiving the buyers of the securities that they originated.

I have a similar reaction to proposals to tighten oversight of credit‐rating agencies. It is true that these agencies have a conflict of interest in rating corporate debt, because they are paid for their rating services by the issuers of the debt that they rate. It is also true that they have difficulty rating highly complex securities. But these things are well known to sophisticated investors—if not, their ignorance is culpable. No one is required to buy an interest in a mortgage‐backed security merely because that interest has been rated triple A by a rating agency. It is reckless to make a large investment on the strength of a credit rating; and if that recklessness was indeed widespread before the crash, it will not be from now on; the investors will have learned their lesson. (Much of the Report is about closing the barn door after the horses have escaped.)

What might call for reform, though ignored in the Report, is the SEC’s certification of the leading creditrating agencies as “Nationally Recognized Statistical Rating Organizations.” (Ten have now been certified, including the two leaders—Moody’s and Standard and Poor’s.) Such certification allows the issuers of debt rated by an NRSRO to provide prospective investors with a less elaborate offering document. And apparently some customers of American Insurance Group allowed AIG to substitute its triple A rating for collateral to back the credit‐default swaps that it issued. In addition, insurance companies, pension funds, and other investment entities that are permitted to invest only in “investment‐grade” securities cannot be sued for failing to comply with this restriction if the securities they invest in are rated triple A by a NRSRO.
This puts the NRSROs under greater pressure to give the sellers of securities a high rating, and thus weakens market discipline.

There is no good reason for giving a federal stamp of approval to designated credit‐rating agencies, and other privileges denied competitors, just as there is no good reason to have the government sponsor mortgage companies (Fannie Mae and Freddie Mac). But the proposition that NRSRO privileging was a major factor in the financial crash is again dubious, for sophisticated investors—and they are the only customers for tranches of securitized debt—are capable of giving proper weight to an NRSRO’s rating, as they are to give proper weight to the designation of a private company as a “GSE” (government‐sponsored enterprise).

To go beyond stripping the NRSROs of their privileged status, therefore, seems unwarranted by what is known at present about the causes of the crash. In hindsight the credit‐rating agencies may have done a poor job in rating securitized debt, though even this is uncertain, because the consensus view was that securitized debt was safe because it diversified the risks created by the underlying assets (such as the mortgages that back mortgage‐backed securities). But if the rating agencies did do a poor job, and not just in hindsight, the market will punish them if the government allows it to, and it is in this respect that eliminating NRSRO status would be a step in the right direction, as it would increase competition in the ratings industry. Generally, the market disciplines even firms that labor under a conflict of interest, as of course many do—insurance companies obviously, but also accountants, lawyers, doctors, and automobile body shops. If credit ratings are distrusted, credit‐rating agencies will not be able to extract high fees for rating a company’s debt.

The case for the government’s protecting consumers of financial products as distinct from sophisticated investors is stronger, but the government’s efforts should in my view be limited to protecting consumers from fraud. From this perspective the creation of the Consumer Financial Protection Agency would be a step in the wrong direction. There are plenty of remedies against financial fraud, including criminal remedies, and plenty of enforcers, including the Justice Department, the Securities Exchange Commission, and the Federal Trade Commission, and their state counterparts. The new agency, as the Report makes clear, would have the additional and more dubious mandate of protecting consumers of financial products from themselves. There is a telling remark in the Report that oversight of financial markets should be based on “actual data about how people make financial decisions.” The authors believe that consumers do not make financial decisions on a rational basis because they cannot understand financial products. So the new agency if it is created will design “plain vanilla” financial products, such as mortgages, and require that they be offered to prospective borrowers along with the lender’s own product. And the agency is to restrict the terms that lenders offer in their own products if the benefits of the restrictions are deemed by the agency to outweigh the costs. Since no responsible cost‐benefit analysis will actually be conducted, the agency will have carte blanche to impose its view of optimal mortgage terms on the housing market.

In doing so it may for example decide to forbid ARMs—adjustable‐rate mortgages—thought to be a culprit in the housing bubble. What is true is that an ARM is cheaper than the conventional fixed‐rate mortgage because it shifts the risk of interest‐rate fluctuations from the lender to the borrower. But that is a tradeoff (lower rate for greater risk) that a perfectly rational and well‐informed homebuyer might make, especially since a fixed‐rate mortgage with prepayment penalties (which makes refinancing costly), in contrast to an ARM, makes it more difficult for the borrower to benefit from a future decline in mortgage interest rates. The new agency might want to outlaw prepayment penalties as well, though, again, a mortgage that includes such penalties is cheaper than one without, precisely because it denies an opportunity to the borrower; and once again the tradeoff may be preferred by a rational borrower.

Notice the conflict between the mandate of the new agency, which is to protect consumers from foolish credit decisions, and the mandate of the Community Reinvestment Act, to which the Report pledges allegiance, to encourage home financing in “underserved” communities. If mortgage lenders are forbidden to shift risk to the borrowers, such as through ARMs and prepayment penalties, they will charge higher interest rates, and impecunious persons will be prevented from owning a home.

The creation of the Consumer Financial Protection Agency is intended to prevent a repetition of the current financial crisis, yet it has been proposed in advance of evidence that deception or cognitive deficiencies played an important causal role in the crisis. Even if such deficiencies did play a significant role, there is no reason to think that differently drafted mortgage forms, payday loan forms, credit‐card solicitations, etc., would influence consumer behavior. When interest rates are low and credit therefore abundant, Americans borrow. If the new agency’s “standard” financial products result in lower interest rates, Americans will borrow more, setting the stage for a future financial crisis, while if the products result in higher interest rates, they will delay the recovery from the present crisis.

The latter—higher interest rates—are the likelier consequence, because the thrust of the proposal is to pile more rights on consumers, which will raise the costs of the finance companies. This may or may not reduce the amount of consumer indebtedness (which would be a good effect, since overindebtedness is one of the circumstances that has contributed to the economic crisis). The amount of debt that consumers take on will be less, but the burden may be greater because debt will be more costly.

At a time when the entire credit system is fragile, the very proposal of such an agency (coming hard on the heels not only of a raft of other proposals for the regulation of the finance industry but also of a hastily enacted statute regulating credit‐card credit—the Credit Card Accountability, Responsibility and Disclosure Act of 2009, which may substantially increase the costs of credit‐card issuers) is likely to retard the economy’s recovery from its present sickness, if only by further unsettling the economic environment of the finance industry.

In my book, A Failure of Capitalism: The Crisis of ’08 and the Descent into Depression, I suggested a moratorium on financial regulatory reform: wait until the economic recovery is well under way and the causes of the financial crash have been well studied. There is no urgency about financial regulatory reform because there is no imminent risk of another crash. For a time at least, the world’s central bankers, and the financial industry itself, will be hyper‐alert for another housing or credit bubble. The wisdom of delay is confirmed, in my eyes at least, by the proposals in the Report.

But given the pressure to “do something,” I shall make a few proposals, guided by the principles that structural reform—creating new agencies, shifting regulatory power from one agency to another, and the like—is unresponsive to the problems of regulation that the financial crisis has brought to light, and that, in light of our as yet imperfect understanding of the causes of the crisis, modesty should be the watchword.

The first proposal is to commission an in‐depth study of the causes of the financial crisis, along the lines of the study by the 9/11 Commission of the intelligence failures that enabled the 9/11 plotters to elude detection. The essential point is that the in‐depth study be conducted by neutrals rather than by persons who had an official role during the run‐up to the financial crisis. The analysis and recommendations in the
Obama Administration’s Financial Regulatory Reform plan are contaminated, it seems to me, by the complicity of some of the authors (or officials who shaped the analysis and recommendations, whether or not they contributed to the drafting of the Report itself), in the regulatory failures that largely caused the crisis. Instead of acknowledging the causal significance of these failures, the Report tries to shift the blame to the private sector and to structural deficiencies in regulation that—the Report argues unconvincingly—prevented the regulators from anticipating and preventing the crisis.

My remaining proposals are for measures to improve regulatory performance, as distinct from the organization of financial regulation. First, we need a program that will rotate financial regulatory staff among the different financial regulatory agencies, to broaden the perspectives of regulators, reduce the “stovepiping” of information that may relate to a wide range of companies and financial markets, expose regulators to new ideas, reduce turf warfare based on misunderstandings, and make a career in financial regulation more interesting and challenging. The model is the military reforms instituted by the Goldwater‐Nichols Act of 1986 that made service in joint commands a prerequisite to promotion to a senior level.

Second, it would probably be a good idea to finance the financial regulatory agencies out of congressional appropriations rather than fees paid by the regulated firms. The fee system puts the agency and the regulated firms in the approximate relation of seller to customers, and let’s not forget the slogan that the customer always knows best. The particular danger is that a firm will, by configuring its structure in a particular way, bring itself under the jurisdiction of an agency that, desiring to increase its fee income, offers (implicitly of course) a softer regulatory touch. There is the further danger, when an agency is supported out of fee income, of a mismatch between the penalty function of fees and the revenue function. Fees set at the right level to deter risky practices may generate too little or too much income to finance the agency at optimal size.

My most important suggestion is also borrowed from national security. (In recent years I have written extensively on the reform of national security intelligence as well as on responses to catastrophic risks generally, and this writing has influenced my views about the reform of financial regulation—the financial crash of last September was sudden, catastrophic, and unanticipated.) The suggestion is to create, within the Federal Reserve, the National Security Council, or the President’s Council of Economic Advisers, a capability for financial intelligence and emergency financial planning. The regulatory failures that underlie the current depression did not result from a lack of legal authority, as the regulators argue in an effort to excuse their failure, or from the structure—over‐elaborate though it is—of regulation of the financial sector. They arose from lack of foresight and knowledge, and they can be rectified, at least to some degree, by a sharper focus on information collection and analysis and on contingency planning.

These are separate tasks. The first is the pure intelligence task. The Treasury Department already has an intelligence office, the duties of which include detection of financial transactions for the support of terrorists. Keeping track of lawful, but possibly risky, transactions and balance sheets should be easier than unraveling terrorist funding networks. And contingency planning is not wholly alien to financial regulation—think of the stress tests (which were not invented by Secretary of the Treasury Timothy Geithner, by the way, but are a standard tool of bank regulation). Stress tests are designed to identify financial weaknesses before they cause actual bank failures; the object, as the name implies, is to determine whether, if the bank is stressed by adverse economic developments, it can survive. If it flunks the test, there is time to take precautionary measures to avert failure should the stressful conditions materialize.

A rather grim parallel to the idea of contingent financial regulatory planning is the “COG” (continuity of government) plan, which is the plan for ensuring the survival of the U.S. government in the event of a nuclear attack, or comparable catastrophe, that destroyed Washington. It is almost incomprehensible that some counterpart plan was never devised to deal with the possibility of a catastrophic failure of our financial institutions. It is not as if such a failure were unprecedented; it happened in the United States and other countries during the Great Depression, and in Japan as recently as the 1990s. Warnings of a housing bubble and a possible ensuing banking collapse were issued as early as 2002, and gained in frequency and urgency as the bubble expanded and burst. By 2007 a deterioration of the financial system was evident. Even the Federal Reserve expressed concern, but when disaster struck last September, the government was taken unawares and had no remedial plan to put into effect. The Federal Reserve and the Treasury Department reacted vigorously, but in an obviously improvised way that impaired business and consumer confidence. The government’s failure to save Lehman Brothers was an especially serious, and wholly avoidable, blunder.

Financial regulation can be improved without an elaborate reorganization of the regulatory structure; whether it can be improved with such a reorganization may be doubted.

 

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