We have come to the point of no return for this administration – either it charts a drastically different course when it comes to dealing with the financial industry, or it carries on siding with clueless, inept, and in many cases immoral bankers. . . Many of the ideas afoot, like a tax on banking profits or a consumer regulatory watchdog, are helpful but don’t constitute real reform. Here, then, is an insider’s view of what really is necessary.
Step One
Fire Timothy Geithner and Larry Summers, and replace them with people who are not integrally connected to the industry, particularly to Goldman Sachs. Withdraw the nomination of Ben Bernanke as Chairman of the Federal Reserve before it is too late. If possible, replace him with Paul Volcker or someone equally disgusted with the performance and attitudes of banking executives. Fire John Dugan as Comptroller of the Currency. He has been captured by the big banks from the get-go and needs to be replaced by someone who is not afraid to stand up to the industry.
Step Two
Submit to Congress a bill to repeal last year’s instructions to the FASB to modify mark to market practices. The light of day needs to be shed on what the banks own in the way of mortgage backed securities and related derivatives, and public prices need to be applied to these assets. Instruct the GAO to conduct a complete audit of the Fed, not just the limited audit of the AIG transaction that Bernanke has approved.
Step Three
A tax on bank profits is well and good, but does not get to the source of the problem behind aggressive risk taking and obscene bonuses. The real problem is with bank expectations on their return on equity. Banks, especially the top 10 largest in the US, have ratcheted up their ROE targets year by year, so that now they are at least expected to be 15% p.a. or higher. These high targets lead to abuse of leverage, lax accounting, misleading products, and ultimately Ponzi finance, in which higher volumes and greater risk are needed every year to keep the ROE scheme going. To control this, bank regulators need to go straight to the heart of the system within banks that mandates these excessive ROE targets – the hurdle rate of return for transactions. This should be mandated to be no larger than 10% return on assigned capital. Deals which generate a return greater than 20% on assigned capital should no longer be welcomed with glee, but looked at suspiciously for the undue risks involved.
Step Four
Bankers love to say that if they don’t reward their best talent with fantastic bonuses, these people will leave for greener pastures. What this really means is that these people will leave for the hedge fund or leveraged buyout industries, and to a lesser extent the mutual fund industry, all of which pay extremely well. The reason these industries have thrived has been their access to cheap and unlimited credit that allows them to leverage anywhere from 2:1 up to 30:1 for some hedge funds. Without this leverage high ROEs are not possible, and therefore neither are high bonuses. There is no demonstrable economic benefit from hedge fund or leveraged buyout practices, therefore the access to capital for these industries needs to be significantly constrained. Regulators need to go to the source of this capital – the banking industry – and an ideal starting point would be to cap loans to these industries going forward at the levels set in 2009.
Step Five
Financial activities which constitute extraction of equity need to be outlawed. There are a number of examples of this, but two obvious examples include any home equity loan where the borrower is taking cash out from their property not directly related to the purpose of the borrowing or to be used to pay points or fees to the lender; and second leveraged buyout activity where the target is used as collateral for the buyout loan or where the buyer takes dividends out of the target’s retained earnings or pension plan.
Step Six
Get Eric Holder and the Justice Department to work on the many cases of fraud and securities or tax law violations that have piled up in recent years and are now getting stale. The mortgage industry is an obvious source of indictments, but don’t be afraid to look at all the top banking industry executives who ignored warnings from the federal government as early as 2004 that no-documentation loans were rife with fraud (as was the appraisal process). These executives, including CEOs, should have seen these warnings, yet they continued to issue securities to investors without alerting them to the potential problems with the underlying mortgages behind the securities. This is securities fraud, or at the very least negligence of the highest order.
Step Seven
Work closely with all the major international banking regulators and their governments to insure consistent standards on financial reform and tax policies. Regulators should not be allowed to game the system and deliberately put in place lax standards to attract banking business from other countries. This means you, Switzerland!
Step Eight
Prepare the federal government internally, and especially the FDIC, for the possible bankruptcy and collapse of any or all of the big banks, including Citigroup, Bank of America, JP Morgan Chase, and Wells Fargo. Have a well-thought-out emergency plan in place for such a contingency, especially for the FDIC to act as receiver-in-possession and guarantor of all qualifying deposits. Then, announce as clearly and forcibly as you can that Too Big To Fail is officially dead, and then henceforth any financial institution which gets into trouble will receive no bailout from the government but will instead be thrown into bankruptcy.
Especially important is Numerian's note at the end that all of these steps can be taken NOW; they do not require endowing the federal government with new regulatory powers. All that needs to be done is to begin aggressively enforcing laws and regulations already in existence.
The Obama administration doesn’t need to wait for regulatory reform to work its way through years of legislation and court tests.
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