For President Barack Obama, the 2008 campaign was the easy part. Angered by a global financial crisis, voters demanded that the federal government do something to rein in Wall Street — and he promised he would. The United States, Obama said, needs “a 21st-century regulatory framework to deal with these problems.”
Now, five months into his administration, Obama is seeking to put that new regulatory framework in place. In the process, he is learning that using the federal government as a tool to change the way the American financial sector does business is easier said than done.
On June 17, critics emerged as soon as the President unveiled his complex, sweeping financial regulatory proposals — which would give the Federal Reserve Board more power to regulate large, integrated Wall Street firms while also creating a new agency to crack down on abuses by mortgage and credit card lenders. From the political left, pundits said the administration kowtowed to lobbyists for large banks and delivered an overly timid plan, while others on the right complained that too much government intervention would stifle the hoped-for economic recovery.
Several Wharton faculty have their own criticisms of the 85-page Obama plan. For example, finance professor Marshall E. Blume questions why the new administration rushed to propose new regulations before all the information has been gathered about the role played by financial-sector misconduct and abuses in triggering the worldwide recession.
What’s the Rush?
“What they really should have had is a non-partisan group or a committee examining what went wrong,” says Blume, who directs Wharton’s Rodney L. White Center for Financial Research. “This would be a commission of highly respected practitioners and academics who would carefully analyze what happened and what caused the downturn. I think we would get more sensible regulations out of the process. There are some who would argue that the government was partially at fault, but you never hear about that in these regulations.”
Wharton finance Professor Jeremy J. Siegel also questions the pace of the push for reform. “What’s the hurry here? We don’t have any danger of another bubble coming up. Financial institutions are not going to take too much risk in the next year or two, [or] probably in the next decade, given [that] overleveraging almost destroyed them.” Siegel worries that financial regulatory reform is a complex matter that the government should not attempt to tackle as it tries to stimulate the economy, reform the health care system, and fight a war in Afghanistan while withdrawing from Iraq. “I think this adds too much to the plate of Congress, with all the other charges it has to consider over the next several months.”
The Obama administration moved quickly to unveil the proposals, even as Congress was just this spring acting to create an investigatory commission along the lines of the panel suggested by Blume. The administration’s plan was drafted by a team led by Treasury secretary Timothy Geithner. It aims to address a plethora of complaints about the role that unchecked and risky activity by large financial firms played in the run-up to the worst economic crisis since the Great Depression.
The key issues include largely unregulated trading of complex financial instruments, including mortgage-backed securities, which dragged down some of the nation’s largest banks and brokerages as the housing bubble of the mid-2000s collapsed and foreclosures soared. In addition, the proposal aims to tackle widespread criticism of generous pay and bonuses on Wall Street tied to lucrative but risky short-range trading strategies rather than long-term performance.
“I do like a couple of aspects of the plan, such as the fact that it does not attempt to limit financial innovation,” says Mauro Guillén, a Wharton management professor and director of the Lauder Institute. He believes that the proposals discourage overleveraging by banks and financial holding companies, but do not seek to ban other kinds of financial activity. “There is no prohibition on any of the products such as derivatives, including securitized loans, and there is no suggestion that any of these products will be prohibited, although they will be regulated in all sorts of detail.”
Pumping Up the Fed
The Obama administration’s proposal aims to strengthen the Federal Reserve as the primary monitor of large integrated financial houses and, more importantly, to gauge the systemic risks posed by the connections between firms. The plan would have the Fed keep its eyes on a wider range of companies — such as the insurance giant AIG, which played a pivotal role in the meltdown of complex financial instruments — and would allow the government to seize a large financial firm that posed a risk to the wider system.
At the same time, the White House is taking on the problems of individual consumers by proposing a new agency that would tackle some of the mortgage and credit card industry abuses. The new Consumer Financial Protection Agency — the concept of which has been harshly criticized by firms that provide credit to consumers — would not only regulate those industries with an eye toward protecting consumers, but it could also require institutions to retain as much as 5% of the loans they originate, to ensure that they carry an element of risk.
Other key aspects of the Obama plan include better coordination among the key government regulatory agencies as well as first-ever federal regulations on hedge funds, an expanded role for the Federal Deposit Insurance Corp. (FDIC), and a proposal to combine two existing regulatory agencies into a new one called the National Bank Supervisor. The bulk of the plan requires legislative action in Congress that leading Democrats, who solidly control both houses, hope to pass before the end of the year. Still, proponents of the plan will need to address the swelling tide of criticism.
In a detailed presentation on the Obama plan delivered at a recent European banking conference, Wharton finance professor Richard J. Herring said the overall proposal “is in some respects quite bold, in others rather timid.” He ticked off a list of major financial-sector issues that were not covered in the proposal, including a failure to address systemic problems at the quasi-federal housing agencies Fannie Mae and Freddie Mac, scant attention to the role of money market funds, and no action involving the ratings agencies that stand accused of failing in their watchdog role because of conflicts of interest. A key reason for that timidity, Herring noted, is the entrenched power of the existing bureaucratic agencies and their longstanding relationships to both the financial institutions they oversee and the members of Congress who control their purse strings.
Another critic is Wharton finance professor Richard Marston. He argues that old-school politics continues to prevent the Obama administration from going as far as it should to strengthen regulatory oversight. In particular, Marston is disappointed that the proposal does not combine the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) as many — including the previous Bush administration — had proposed. According to a report in The Wall Street Journal, the administration considered but rejected such a plan. Marston suggests that Congress would be reluctant to sign off on that merger because the agencies are overseen by different, influential congressional committees.
“That kind of problem is embedded in a lot of this legislation,” says Marston, who notes there is broad advocacy for a much more aggressive consolidation of federal banking regulators. The plan does propose a new National Bank Supervisor, which would be a combination of the Office of Thrift Supervision and the Office of the Comptroller of the Currency, both now units of the Treasury Department.
The expanded role for the Fed is also generating considerable controversy, especially in Congress, as critics say the central bank failed to offer leadership or move swiftly enough during the run-up to the global economic meltdown as it unfolded over the last couple of years. Herring also notes that some lawmakers are wary of the Fed’s proposed expanded role because they believe widespread use of the central bank’s dollars during the recent crisis was a means for companies to elude legislative oversight.
The Fed responded admirably to the unfolding crisis, Marston argues. “The number one reason [why the] economic crisis has turned into merely a business recession was quick action by the Fed,” he says. “Last fall, that made all the difference in the world when commercial paper had broken down and the LIBOR [London interbank overnight rate] rate was going crazy, and now those markets are back. What was missing during the crisis was the ability of regulatory agencies to seize and close down in an organized manner some of the large institutions that caused systemic risk.”
According to Guillén, the Fed — while not perfect — may prove to be the best choice for financial industry oversight because of its independence; the Fed chairman is nominated every four years and overlaps presidential administrations. “The potential benefit of doing this through the Federal Reserve is that this body has been very autonomous, very independent,” he says. “All the other agencies that are being created or that already exist fall in some way under the umbrella of pressure.”
Blume says a significant question is why so many new regulators and regulations are needed now when in recent years the regulators already in place were not doing their jobs well. “If you look at companies like AIG, they already were regulated by the government — they were regulated by the Office of Thrift Supervision — and it didn’t work. Now, realizing that regulations were already there and that they didn’t work, you have to ask yourself if additional regulations would have worked. You could have a mechanic who didn’t repair a car right, but if you have 32 mechanics and they don’t do it right, the car still isn’t repaired.”
Others agree that shoddy oversight by existing regulators is a problem that is not easily fixed by any new layer of regulators. Herring, in his recent presentation, noted that “many problems don’t require new laws, simply the appropriate enforcement of existing laws.”
Another aspect of the plan that is important but has drawn less attention, Guillén points out, is a proposal to reshape the way that brokers are compensated for their trading activities by emphasizing the long-term performance of the assets they trade. The Obama plan would also give the SEC the power to block financial compensation for trading products that are not in the investor’s best interest and also to enhance disclosure requirements.
However, the initial version of the plan has only the vaguest language on the much debated issue of executive compensation, even though Obama and others have in the past identified exorbitant pay for CEOs and other financiers as one of the root causes of the economic crisis. The plan merely states: “Federal regulators should issue standards and guidelines to better align executive compensation practices of financial firms with long-term shareholder value.”
Wayne R. Guay, a Wharton accounting professor who specializes in compensation issues, says that if Congress and regulators plan on tackling executive pay more aggressively, they would be wise to focus less on the overall amount of compensation and more on whether that compensation is tied to risky actions aimed at protecting shareholders over other key stakeholders. “It’s reasonable for regulators and the White House and taxpayers to ensure that incentive schemes provide executives with the incentive to maximize share value but also look after the interests of the taxpayer.”
Regardless of what the President is proposing this summer and what the experts think now, the final product will be the result of a grueling process on Capitol Hill — which Herring notes will be influenced by an overloaded congressional calendar as well as the ambitions of key players. He singles out Democrat Rep. Barney Frank of Massachusetts, who chairs the House Financial Services Committee and who believes “that it’s crucial to deal with crisis intervention tools, less so with crisis prevention tools,” and Democrat Sen. Christopher Dodd, the Senate Banking Committee chair, who is oriented toward consumer protection. The new consumer protection agency and the coordinating Financial Services Oversight Panel are strong possibilities for 2009 enactment, but other aspects may have to wait, Herring predicts.
“Congress’s power to delay is virtually unlimited, even when controlled by one party which has elected a popular president,” Herring adds. “With so many priorities, the President will need to pick his battles carefully.”