Smarter Financial Regulation? Look to Brazil

Good Evening: Just when the bandwagon otherwise known as the rising U.S. equity market looked as though it might throw a wheel today, prices recovered and stocks rolled to another advance. The gains were small and the volumes remained light, but the growing number of optimists will take it. The Australian central bank may have raised rates (up 25 bps today), and the bailout plans for Greece may be looking more slippery by the day, but equity investors in this country needed only to see some harmless from last month’s FOMC meeting and their courage was restored. What will happen to our markets should things in Greece really become unstuck is an open question, but it looks like market participants want to see how the S&P 500 handles the 1200 mark in the near term. I would prefer seeing Congress take a moretoughtful approach to the financial reforms under review. Perhaps they can take their cue from how the punishment for financial losses gets meted out in Brazil.

Global equities were on the defensive overnight after the Reserve Bank of Australia raised its benchmark rate for the fifth time in its last six meetings. Rumblings about just which institutions actually will stand behind Greece and its debt issuance also didn’t help, and U.S. stock index futures pointed to a lower opening this morning. Stocks did indeed open down 0.5% or so, but those losses were mostly recovered before the mid day release of the March FOMC minutes. The minutes — indeed the entire March meeting — could be summed up in the following sentence: “We are not budging on rates today, nor are we likely to for at least six months”.

The major averages then spent most of the afternoon hovering just above unchanged. By day’s end, the Dow’s virtually unchanged close lagged the others, while the Russell 2000 again led the way with a gain of 0.5%. It’s only my opinion, but it will be tough to push equity prices down very much as long as small and midcap stocks continue to outperform. Treasurys enjoyed a respite from the recent selling in that market and rates eased between 1 and 4 bps. The dollar was mixed and commodities pulled back a bit. Though energy prices remained firm, the CRB index retreated 0.4% today.

Below you will find a Bloomberg interview with author, Roger Lowenstein, about his book, “The End of Wall Street”. In the interview, Mr. Lowenstein discusses the late, great credit bubble, but he hints that attempts to regulate Wall Street in the bubble’s aftermath should be thoughtful ones. I agree. Many want to blame the climate of deregulation in recent years for the financial mess we now find ourselves in, but those lax regulatory standards took decades to erode. President Obama has indeed brought change, but the fear is that he wishes totally re-regulate, thus involving government too heavily in too many industries. Perhaps the best financial regulation is not the “all or none” debate into which the major political parties so often descend. Smarter regulation would involve a hybrid of both philosophies.

1) Require all financial institutions to keep all assets and liabilities ON the balance sheet
2) Require better and more detailed reporting of all financial exposures (i.e. disclose the cost of each asset, its current market price, as well as a fair value estimate of each asset — put everything on the table for the regulators). We should require mark-to-market accounting when calculating the leverage ratios described next.
3) Require a hard cap on leverage of no more than 10 to 12 times tangible common equity. This cap must apply to all financial institutions wishing to do business in the U.S. and needs to be coordinated with EU and Asian financial overseers. It also must be imposed over time in order to give institutions a reasonable chance to comply.
4) Require ALL Credit Default Swaps (CDS) to be listed on large exchanges. Without the transparency entailed in exchange-listed positions, and without the rigorous discipline of meeting daily margin calls — in cash, as with other listed derivatives — the ever growing mountain of intertwined CDS exposures will threaten any and all future regulatory regimes.
5) Require all firms originating a securitization deal to retain a small portion of each transaction on its books. Eating what they cook will force financial institutions to employ better underwriting standards. If these firms whine about how they’ll pay for it, let them use the funds accruing in their employee bonus pools.
6) Once these rules are in place and once the leverage has been worked down to the cap levels, then let the banks decide for themselves which businesses they lend to and which markets they participate in. Government should have no role in making these decisions and should stand aside as long as those institutions stay within these “boundary fence” rules.
7). In order to give the above framework some teeth and convince management that they have to manage with NO future expectation of a federal bailout, the final step is to abolish the “too big to fail” doctrine. Let managements and shareholders know up front that there will be no more AIG life-lines. Troubled institutions in the years ahead will be either wound down or merged, just as Indy Mac, WaMu and Wachovia were during this cycle. As Mr. Lowenstein suggests, we may not need to go back to the days of Glass-Steagall in order to accomplish this goal.

In short, I’m proposing a large and well enforced boundary fence type of regulatory framework inside which banks and other financial institutions can more or less freely operate. Government intervention (as with GM & Chrysler) and rule making on a micro scale is just as wrong-headed as letting the banks do whatever they want. Placing visible and enforceable borders around financial institutions will work precisely because it acknowledges both human dimensions so common to capitalism — the freedom of choice that allows Adam Smith’s Invisible Hand to operate, and the Visible Fist of government that tries to prevent the greedy from gaming the system in ways dangerous to us all. Though the Rio Grande river gets more attention, this is the type of “border security” legislators should focus upon.

The recent proposals by Senator Dodd do not go far enough in reining in a financial system that still incentivizes excessive risk taking. The suggestions I’ve made above are no panacea, either, but if any of them seems even the least bit Draconian to those occupying the corner suites on Wall Street, they should be very thankful our Congress has not yet adopted the Brazilian approach to financial regulation. In the most recent cover story of “Grant’s Interest Rate Observer” (, Jim Grant casts an approving eye on the Brazilian practice of holding a bank’s officers and board members accountable when things go awry at the institution they are charged with guiding. He quotes two principals at Dynamo Capital, who relate that “the net worth of officers and board members is blocked in cases of litigation, losses arising from negligent management or filings for bankruptcy.”

Having one’s net worth on the line while in office is sobering enough for a bank manager or director, but the Brazilians have added a sharp claw-back provision as well. The rule is in effect not just when managers and directors are on the job but also for a full five years after they leave office — longer if legal proceedings are the unfortunate result. What a great concept; with the chances for reward come the full responsibilities for failure! It makes one wonder whether Chuck Prince would have still been dancing in 2006/2007 if every penny he owned was on the line, or if Dick Fuld would have thought twice before levering Lehman’s equity thirtyfold or more.

In the not too distant past, Wall Street firms were partnerships and bank shareholders were liable when the bank they owned hit the rocks. Since we can’t turn back the clock, and since the average Congressperson is unlikely to understand half of my above-listed suggestions (let alone enact them), I would reluctantly settle for the following reforms: Put CDS on proper exchanges; institute a hard cap on leverage of no more than 12 times tangible common equity; and put in place a Brazilian-inspired rule to hold managers and directors financially responsible for failure. As long as banks are run by human beings, we’ll never be able to prevent bankers from making dumb decisions. But with these simple and enforceable border mechanisms in place, we can at least lower the systemic costs of those poor decisions while requiring those who made them to shoulder as much of the financial burden as they can bear. Who knows? Maybe even our contentious Congress will grasp the benefits of these ideas just long enough to pass them. If not, then November is but seven short months away.

— Jack McHugh

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