Last week, the Administration issued a much-publicized white paper laying out its proposals to reform the structure of financial services regulation.  Debate over the various elements of the Administration’s plan is likely to be both protracted and fierce; battle lines inside the Beltway are already being drawn.

The white paper is an excellent starting point for that debate.  But despite its seeming comprehensiveness -- the paper is, after all, nearly 90 pages long -- the proposal advances truly significant reforms with respect to only two out of five structural pillars of the U.S. financial services market.  Its proposals on those two pillars (consumers, and bank management teams) seem reasonable, and in some cases, bold and compelling.  We should not understate the potential power of some of those bold policy “hammers.” 

Strangely, though, the Administration proposal is affirmatively milquetoast with respect the three remaining pillars of the financial services market (bank boards, debt markets, and regulators).  Effective reform will require a more aggressive approach.

The Role of Regulation and Governance

Before delving into the reform proposals themselves, it is useful to agree on a mental model for the appropriate role of regulation and governance in the financial system.

The financial markets -- including both the banking system and the “shadow banking system” -- are, at their heart, private sector mechanisms by which capital is allocated and priced.  That capital allocation and pricing occurs every day, in millions of atomized transactions, each typically struck between two seemingly arms-length, independent counter-parties:  firms’ management (that is, the human and technological decision-making apparatus of banks, finance companies, hedge funds, and the like) and customers (that is, corporates, small businesses, and consumers).  The terms upon which those transactions are struck, taken in aggregate, represent a market-driven consensus on the appropriate balance of risk and return in the financial system.

But there are two profound problems with this market-driven balance:  moral hazard, and information asymmetry.  The result is the seeming clumsiness of the invisible hand in financial services.

First, moral hazard afflicts both counter-parties in a typical credit transaction.  Both management teams and customers have a shared bias towards a higher ambient level of risk.  As has been much noted recently, bank executives tend to be rewarded, both financially and psychologically, when high risk bets pay off, but they do not suffer commensurate negative consequences when high risk bets fail.  They are, after all, playing with the bank’s money, not their own.

Although it is less remarked upon, customers have the same kind of bias towards higher risk and higher leverage.  If a bank is willing to lend you $475,000 to buy a $500,000 house, you have all of that house’s appreciation to gain, but only $25,000 to lose if you are willing to walk away and default.  Like bank executives, consumers are playing (mostly) with the bank’s money, not their own.  Granted, customers tend to be less explicitly mercenary than commercial enterprises about this heads-I-win, tails-you-lose proposition, but they absolutely (and rationally) tend to err towards greater leverage, and greater risk, when it is made available. 

The second distortion is the inherent information asymmetry between lenders and borrowers.  This tends to manifest itself in two ways, both of them gruesome.

When borrowers have material information about their own creditworthiness that lenders lack, the result is typically “adverse selection,” which results in too much credit being extended to risky borrowers.  To see this in action, and if you dare, take a look at the credit performance of the Golden West-Wachovia-Wells Fargo option-ARM portfolio. 

In other cases, lenders have superior information.  For example, although banks know, empirically, the rate at which credit card customers will trigger over-limit fees, individual customers systematically (and drastically) underestimate the frequency with which those fees will be incurred.  Because of that underestimation of the true costs of the product, consumers tend to borrow more than they would if they were privy to perfect information.  In the case of American consumers (as opposed to commercial customers), this tendency is further reinforced by a notable deficiency in average financial literacy.  It is difficult for a consumer to conclude he is taking too much risk in his mortgage if he can’t quite figure out how much he is paying in the first place.

Taken together, the distortions created by moral hazard and information asymmetry generate a significant pro-risk bias for both bank management and bank customers.  Given that, it should not be surprising that they will, if left unchecked, systematically introduce more risk into the financial system than would decision-makers without such biases.  And, therefore, it should not be especially surprising if such an unchecked system periodically blows up, leaving bewildered and beleaguered taxpayers to pick up the pieces.

This mental model of the financial system makes clear the need for appropriate checks on risk-hungry bank management and customers.  Those checks are, in theory anyway, provided by the three other pillars of the system -- the three sets of watchdogs:  bank boards, debt markets, and regulators.  It is useful to think of these watchdogs as patrolling concentric circles.

The interior circle:  Banks’ boards of directors, as the stewards of shareholder interests, should rein in management teams’ risk-taking when it advances management’s interests over shareholders. 

Next:  Debt markets (that is, banks’ creditors and uninsured depositors) should rein in bank boards from taking risks that promote equity holders’ upside over debt holders’ safety. 

And, the ultimate line of defense:  Regulators should rein in the combined activities of all of the aforementioned actors (customers, management, boards, and debt markets), when they work to promote their own upside over the safety of insured depositors and the system’s stability at large.

The credit bubble, and the ensuing financial crisis, were the result of a simultaneous catastrophic failure of governance and regulation.  Despite the popular outcry about the avarice of bank executives, and growing backlash about irresponsible borrowing, the fact is that both executives and customers behaved in precisely the way that they always behave if unconstrained:  they sought to take on more risk, and more leverage, wherever it was available.  But all three watchdogs -- bank boards, debt markets, and regulators -- were sound asleep.

The Hammer . . .

The Administration’s proposal takes a reasonable approach to two of the five actors just described.

Consumers.  Perhaps most striking is the approach to consumer protection.  As I’ve described in the past (in an essay entitled “Blazing Toasters”), the proposed Consumer Financial Protection Agency represents a much-needed strengthening and unification of what otherwise has been a fragmented, expensive, and haphazard approach to supervising the kind and quantum of risk that bank managements and consumers would otherwise introduce into the system.  At the same time, by preventing an abusive and predatory race to the bottom, the new agency would actually encourage product innovation. 

Indeed, if anything, I would argue that the Administration has not gone far enough:  the new agency should not just preempt existing federal consumer protection efforts, but also state regulators, whose efficacy at consumer protection has been inconsistent at best.

Bank Executives.  The approach to controlling bank management teams’ risk asymmetry is also well reasoned, and judicious in that it does not attempt to do too much through the blunt instrument of compensation curbs.  I have argued in the past (in an essay called “Outrage Abhors a Vacuum”) that executive compensation reforms should be based on generalized principles that align management interests with those of shareholders, and that apply to all financial institutions (not just TARP recipients) because they are all subject to the risk asymmetry incident to FDIC insurance and other taxpayer subsidies.  This is the general approach favored by the Administration’s white paper.

. . . and the Fickle

Unfortunately, the Administration’s proposal does little to improve the performance of the three systemic watchdogs -- and in some ways makes the situation worse.

Bank Boards.  The white paper is almost totally silent on reforms that would improve the performance of banks’ boards of directors.  This is odd.  After all, it was bank boards that enabled management teams to take on risk to shareholders’ detriment; it was bank boards that pursued ill-timed dividend policies and stock buyback programs that eviscerated capital levels; it was bank boards that gave the green light to M&A deals that turned winning firms into losers overnight.

This question of improving board performance is not trivial.  The right approach is likely to involve tweaking incentives (many academics have pointed out the pernicious influence of typical compensation practices); building capabilities (Bank of America’s board until this weekend included two famous career military officers -- why?); and changing reporting structures (bank boards have virtually no visibility into firm performance without management intermediation).  Doing nothing at all, however, is not at option.

Debt markets.  Of course, even a top-tier bank board will seek to take on risks that benefit equity holders, to the detriment of debt holders -- after all, directors work for shareholders, not bondholders.  That is why efficient financial services markets require active, at-risk debt investors to check banks’ risk-taking.  During the credit bubble, this ceased to happen.

The debt markets’ failure to discipline risk-taking behavior can be ascribed to three kinds of problems.  First, creditors -- especially in the inter-bank market -- were crippled by the opacity of certain derivative exposures, especially over-the-counter credit default swaps. Second, debt investors, particularly in the asset-backed markets, relied almost entirely on the judgments of credit rating agencies, which proved eminently fallible.  And finally, the debt markets relied heavily on the generally implicit government guarantees standing behind firms perceived as too big to fail. 

Containing contagion through derivatives.  Thankfully, the Administration has withstood the initial wave of broker-dealer lobbying with respect to OTC derivatives.   The white paper contemplates bringing much transparency to execution, settlement, and clearing in the OTC derivatives market.  Indeed, it might fairly be argued that most of the benefit of those proposals would be gained with a more targeted approach that focuses purely on inter-dealer credit derivatives, or on credit derivatives more broadly but not rate derivatives.

Overhauling the role of rating agencies.  The proposal is less promising, at least at this early stage, when it comes to credit rating agencies.  In fairness, the problem of rating agencies is an especially thorny one, and the white paper does flag ongoing efforts to reform agencies’ (i) incentives (they are traditionally paid by issuers, but purport to provide opinions that guide investors); (ii) disclosure practices (for example, rating agencies probably should have mentioned that the robustness of structured credit ratings is fundamentally worse than for single-name corporate ratings); and (iii) structural role (the white paper advises that regulators should reduce their reliance on rating agency judgments in their supervisory activities).

The last of these efforts -- hemming in the very role of credit rating agencies -- is the beginning of the structural reform that is necessary.  Let me offer a simple guide for further delineating their proper role.

Rating agencies are not wholly abominations.  By providing scale for buy-side investors, in theory they should mitigate the information asymmetry between investors and issuers, thereby yielding better market-driven pricing for securities.  Their downside is also -- especially in retrospect -- quite clear.  By concentrating what otherwise would be atomized risk-return decisions among debt investors, rating agencies radically tempered the ability of debt markets to provide discipline on financial risk-taking. 

Defining the right role for rating agencies should come down to determining where that downside of decision-making concentration is exceeded by the upside of scale economies.

I have a hypothesis on what that analysis will yield:  The right role for rating agencies is in those markets where their opinions are based on privileged access to issuers that institutional investors cannot themselves efficiently replicate.  The wrong role is in those markets where their opinions take widely available data, and simply perform assumption-driven modeling exercises.

In other words, I suspect we will find that rating agencies should be a shortcut to scale, not a shortcut to judgment.

Ending implicit government support.  The proposal almost entirely punts on the issue of implicit taxpayer guarantees.  Indeed, by creating a new class of too-big-to-fail firms (the “Tier 1 FHCs”), the proposal risks replicating the disasters of Fannie Mae and Freddie Mac.  The reason Fannie and Freddie were able to grow so large, even as their risk-taking seemed so facially problematic, is that debt investors were willing to funnel liquidity to them, confident that the U.S. taxpayer would foot the bill when things went wrong.  And, of course, to debt investors’ satisfaction and the taxpayers’ chagrin, they were right.

Without coming to some conclusion about the future role of Fannie Mae and Freddie Mac, it could (and it should) be difficult for Congress to sign up to create more risk of quasi-GSEs in the form of Tier 1 FHCs. 

Fannie and Freddie are two of the largest financial institutions in the history of the world.  The notion that we can somehow reform the broader system, without any real conception of their role, is misguided.

Regulators.  The approach to the ultimate watchdogs -- regulators -- is a bit of a mixed bag.  We should recognize that this is an exercise in constrained optimization; any proposal would have been certain to have clear advantages and disadvantages.  In this way, the white paper does not disappoint:  It is both very good, and very bad.

First, let’s recap the positive features.

Most critically, the proposal gets the most demonstrably flawed agencies out of the business of bank regulation.  It effectively consolidates the OTS into the OCC, and reaffirms the termination of the SEC’s disastrous Consolidated Supervised Entity Program.  No regulatory body covered itself in glory in the run-up to the crisis, but the SEC and the OTS were truly astonishing failures.  The SEC, in a move that seemed bizarre even at the time, allowed its largest charges to load up on liquidity risk, and run some 30-to-1 leverage.  Not surprisingly, one of the largest of those investment banking firms (Lehman) collapsed; two others were forced, with taxpayer-financed sweeteners, into the hands of commercial banks (Bear, Merrill); and the other two (Goldman, Morgan Stanley) received a dead-of-night reprieve from the Fed by being designated bank holding companies.  The OTS’s track record is just as dreadful:  its largest charges included such luminaries as AIG, Washington Mutual, Countrywide, and IndyMac. 

Second, the regulatory proposal eliminates some of the more glaring and damaging loopholes in bank holding company supervision, including thrift holding companies and industrial loan companies.  Contrary to the baffling assertions of Senator Bennett (from Utah, the home of most of nation’s industrial loan companies) that “there is not a single ILC that contributed to the crisis,” the ILC loophole allowed firms like Merrill Lynch and GMAC to build huge balance sheets with the help of FDIC-insured deposits, all while avoiding holding company supervision by the Fed.  They are both now, to greater or lesser degree, wards of the state.  (For a discussion of GMAC in particular, see my essay entitled “Dead Bank Walking”).

These are obvious strengths of the Administration’s approach; but the weaknesses should be obvious too.

Much criticism has already been leveled at the proposed role of the Federal Reserve Board in supervising systemically important firms (the aforementioned “Tier 1 FHC’s”).  Congressional leaders from both parties appear concerned about the Fed’s past track record and current capabilities to take on such a role, and about how that role might complicate its primary responsibility as the (mostly) independent steward of monetary policy.  Those are legitimate concerns.

Even if we were to craft a palatable balancing act between the Fed’s historical role and its new responsibilities, though, the Administration has failed to simplify the regulatory regime over which the newly empowered Fed would preside.

Other than the demise of the OTS, the alphabet soup of federal regulators would remain more or less intact under the proposal.  And, strangely, the proposal would roll back the preemptive powers of some national bank regulation, thereby adding the complexity of 50 states’ regulatory schemes.  The net effect will be to increase the number of regulators in our already embarrassingly balkanized framework. 

This is a problem in every way. 

First and most obviously, multiple parallel regimes create nooks and crannies in regulatory coverage.  There are, literally, thousands of very clever professionals in investment banks and law firms who make shockingly good livings taking advantage of such regulatory interstices.  It may be politically expedient, for example, for the Administration to propose retaining both a CFTC and an SEC, but no amount of “harmonization” -- as the white paper prescribes -- will prevent arbitrage by smart practitioners.  And if one could, in unprecedented fashion, truly create harmonized regulatory schemes between otherwise rival bureaucracies, then the argument for maintaining them separately would only weaken further.

Second, multiple regulatory agencies with overlapping authority waste time and energy in jurisdictional squabbles.  To make policy changes, redundant agencies must work together, and the process of coming to consensus can take, quite literally, years -- even as the markets evolve ever faster.  The white paper itself points out a painful example of this:  the snails-pace development of final federal regulatory guidance on “non-traditional mortgages,” which arrived in the middle of 2007, exactly after most of the subprime, Alt-A and Option-ARM horses had already left the barn and attacked all the other farm animals.  (On a related note, this is why, as discussed above, the proposed CFPA should preempt all state and federal authorities on consumer protection issues).

Third, sustaining a patchwork of agencies will make it difficult to upgrade regulatory capabilities.  Recall that, beyond the abstractions of their institutional histories and arcane legislative provenance, these agencies function through the judgment and energy of actual people.  Regardless of the shape of our regulatory structure, if our goal is to regulate better, we will have to recruit, develop, and retain talented regulators.  These are not easy jobs -- at least not when they are done right.  By creating multiple, low-prestige, sub-scale regulatory fiefdoms, we have made it nearly impossible to programmatically attract the best and brightest. 

* * *

Last week’s white paper is a solid starting point, but we must be more expansive -- that is, we must strengthen all three watchdogs, not just regulators.  And we must be more bold -- that is, we must be willing to face the issues that we know to be politically challenging.  The Administration has shown the courage in other contexts to take on real issues, despite profound political complexity.  This should be no different.

Raj Date is the Chairman and Executive Director of the Cambridge Winter Center for Financial Institutions Policy.  He is a former McKinsey & Company consultant, bank senior executive, and Wall Street managing director.