The SEC vs. CEO Pay. By RUSSELL G. RYAN
The agency stretches the law to confiscate a bonus.
WSJ, Aug 05, 2009
A lawsuit filed on July 22 by the Securities and Exchange Commission (SEC) should send a mid-summer chill down the spine of every chief executive and chief financial officer of a U.S. public company.
Exploiting an ambiguously worded phrase in Sarbanes-Oxley, the agency has for the first time claimed that it may under that law “claw back”—some might say confiscate—bonus money and stock sale proceeds from CEOs and CFOs even when it lacks evidence to charge them with wrongdoing.
Sarbanes-Oxley was rushed through Congress in the summer of 2002 in reaction to public outrage over notorious corporate accounting failures at Enron, WorldCom and other companies. As is often the case with such far-reaching and hastily conceived legislation, many of its details were half-baked, poorly worded, and riddled with ambiguity.
A prime example was the so-called clawback feature of Section 304, which was designed to prevent crooked CEOs and CFOs from taking home big bonuses and cashing out company stock while they were knowingly defrauding shareholders. It empowered the SEC to force these executives to reimburse their companies for all bonuses and stock sale proceeds received during any financial period for which their company was later required to restate its financial statements due to “misconduct.”
But in its haste to “do something” about the scandal of the day, Congress muddied the question of whether the “misconduct” required for such a clawback had to be committed by the executive himself (or at least known to him), or could be that of a subordinate, completely unbeknownst to the executive.
Many executives and legal advisers have cautiously assumed that bonuses and stock proceeds were at risk only for executives who actually engaged in misconduct themselves—or at least were aware of it and acquiesced. In fact, the SEC itself has rarely used this feature of Sarbanes-Oxley at all, and had done so only in cases where it alleged personal misconduct by the targeted chief executives or chief financial officers. A prominent example was the agency’s stock-option backdating case against Dr. William McGuire, the former CEO of UnitedHealth Group.
But the SEC has abruptly changed course. It has sued Maynard Jenkins, the former CEO of CSK Auto Corporation, an auto-parts company that had previously settled with the agency on charges of accounting fraud after restating three years’ worth of financial statements.
Several subordinate executives have been charged with both civil and criminal securities law violations. But the SEC has never accused Mr. Jenkins of any wrongdoing. In a press release announcing this case, the agency highlighted its novel position that no such accusation—much less proof—was necessary to claw back his bonuses and stock sale proceeds for the three years in question, which totaled more than $4 million.
Mr. Jenkins is contesting the lawsuit, and he has grounds for optimism. On a visceral level, it seems shocking that a U.S. law enforcement agency could take more than $4 million from any citizen without so much as an accusation of personal misconduct, or at least knowing acquiescence in someone else’s misconduct. Indeed, according to a report by Bloomberg, two of the SEC’s five commissioners voted not to file the lawsuit at all.
In an unrelated case earlier this year, the SEC unsuccessfully argued an equally aggressive interpretation of Section 304. Stretching the law’s wording that clawbacks are appropriate only when a company is “required to prepare an accounting restatement,” the agency argued that Section 304 also allows clawbacks when no restatement is actually prepared, so long as the SEC later concluded the company should have done so.
A federal judge in St. Louis rejected that theory and threw out the charge. In recent years, courts have similarly rejected the agency’s overly aggressive interpretations of laws preventing “selective disclosure,” insider trading, aiding and abetting, and other violations.
The irony is this. Despite all the recent criticism the SEC has taken for supposed laxity in its enforcement program, the agency has in fact consistently taken very aggressive positions in its enforcement cases, such as with laws concerning foreign bribery, market timing of mutual funds, and many forms of insider trading.
For the most part, investors expect the SEC to push the envelope to protect their interests. But the wisdom and fairness of pursuing no-fault clawbacks from unaccused executives is dubious at best.
Mr. Ryan is a securities lawyer and was an assistant director of the Securities and Exchange Commission’s division of enforcement from 2000-2004.
Tuesday, August 4, 2009
‘Blue Dogs’ or Corporate Shills?
‘Blue Dogs’ or Corporate Shills? By Thomas Frank
WSJ, Aug 05, 2009
Capitalism is said to be in terrible trouble these days, with the profit motive suffering rampant badmouthing. Entrepreneurs are facing criticism, damnable criticism. And this criticism must stop.
If we don’t watch what we say, some warn, the supermen who shoulder the world will soon grow tired of our taunting, will shrug off their burden and walk righteously away, leaving us lesser mortals to stew in our resentment and envy.
So far have things gone that the editors of the Washington Post, ever vigilant against deteriorating public morals, apparently decided last week that Americans required a strong dose of instruction in the basic principles of their old-time economic religion. Stephen L. Carter, the famous law professor from Yale University, took the pulpit. And from the heights of the Post’s op-ed page, he instructed us to cheer whenever we discovered that someone was making money.
“High profits are excellent news,” he intoned. “The only way a firm can make money is to sell people what they want at a price they are willing to pay.”
Since that’s the one and only way a firm can make a profit—fraud isn’t a problem, I guess, nor are subsidies or cherry-picking or price-fixing or conflicts of interest—profit is a foolproof sign of civic uprightness.
Professor Carter’s essay was supposed to be a word of caution in a dark, anticapitalist time. But if you read your newspaper closely, it’s not hard to spot glimmers of profit-taking here and there. For example, while some see the city of Washington as a stage for anticorporate posturing, in fact it is ingeniously entrepreneurial.
Consider the “Blue Dog” Democrats, whose money-making ways were the subject of a page-one story in the Washington Post on the very day after Mr. Carter’s sermon. The Blue Dogs, as the world knows, are the caucus of conservative House Democrats who have been much in the news of late for their role in weakening the Obama administration’s plans for a public health-insurance option.
Much of the writing about the Blue Dogs revolves around the question of why they do what they do. What makes the Dogs run? Where did they get their peculiar name? And why do they chase this car but not that one?
The Blue Dogs’s official caucus Web site answers with rhetorical tail-chasing in which “centrism” is so exalted that it justifies any position the centrist takes by virtue of the label itself. The slightly more sophisticated explanation currently in vogue with the media—the Dogs come from heartland districts where the culture wars are a big deal—helps even less.
As the syndicated columnist David Sirota pointed out last week on the OpenLeft blog, having constituents who care deeply about, say, gun rights doesn’t really have anything to do with the pro-corporate stands on mortgage modification and health insurance that have made the Blue Dogs famous.
Friday’s page-one Post story about the Blue Dogs suggests a far simpler explanation: Entrepreneurship. In addition to everything else, the Dogs are champion fund raisers. Individual Dogs do far better than garden-variety Democrats when it comes to bringing in contributions from folks with business before Congress, like the insurance industry and the medical industry. According to CQ, their political action committee is the only Democratic PAC to rival the big Republican dogs; in 2009 fund raising it has been bested only by Mitt Romney’s gang.
So this is the Blue Dogs’ day, with games of fetch down on K Street that had me reminiscing, as I read the Post’s description, about the times when Tom DeLay and his pack did their own tricks for industry’s table scraps.
My guess is that the Blue Dogs, like Jack Abramoff’s Republicans before them, are more keenly attuned than their colleagues to that force of universal goodness, the profit motive. Theirs is simply a less ferocious version of what we had before, with cuddly bipartisan righteousness replacing the fierce red-state righteousness of DeLay’s dogs. But the master is the same as ever, and surely we can still count on the profit motive to deliver the very best in public policy.
Still, there remains the problem of the senseless moniker, “Blue Dog.” In the interests of improved political nicknames, let me propose an alternative. Back in 1932, the future Illinois Sen. Paul Douglas advised progressives not to expect too much from the Democratic Party. It was, he wrote, “maintained by the business interests” as a kind of “lifeboat.” Whenever the GOP ship sprung a leak—whenever Republicans were no longer willing or able to do business’s bidding—the interests simply piled into the other party and made their escape.
The Democrats have improved considerably since those days, at least from a progressive standpoint. But there are still branches of the party willing to carry out the ancestral mission. Let’s call them what they are: the lifeboat caucus.
WSJ, Aug 05, 2009
Capitalism is said to be in terrible trouble these days, with the profit motive suffering rampant badmouthing. Entrepreneurs are facing criticism, damnable criticism. And this criticism must stop.
If we don’t watch what we say, some warn, the supermen who shoulder the world will soon grow tired of our taunting, will shrug off their burden and walk righteously away, leaving us lesser mortals to stew in our resentment and envy.
So far have things gone that the editors of the Washington Post, ever vigilant against deteriorating public morals, apparently decided last week that Americans required a strong dose of instruction in the basic principles of their old-time economic religion. Stephen L. Carter, the famous law professor from Yale University, took the pulpit. And from the heights of the Post’s op-ed page, he instructed us to cheer whenever we discovered that someone was making money.
“High profits are excellent news,” he intoned. “The only way a firm can make money is to sell people what they want at a price they are willing to pay.”
Since that’s the one and only way a firm can make a profit—fraud isn’t a problem, I guess, nor are subsidies or cherry-picking or price-fixing or conflicts of interest—profit is a foolproof sign of civic uprightness.
Professor Carter’s essay was supposed to be a word of caution in a dark, anticapitalist time. But if you read your newspaper closely, it’s not hard to spot glimmers of profit-taking here and there. For example, while some see the city of Washington as a stage for anticorporate posturing, in fact it is ingeniously entrepreneurial.
Consider the “Blue Dog” Democrats, whose money-making ways were the subject of a page-one story in the Washington Post on the very day after Mr. Carter’s sermon. The Blue Dogs, as the world knows, are the caucus of conservative House Democrats who have been much in the news of late for their role in weakening the Obama administration’s plans for a public health-insurance option.
Much of the writing about the Blue Dogs revolves around the question of why they do what they do. What makes the Dogs run? Where did they get their peculiar name? And why do they chase this car but not that one?
The Blue Dogs’s official caucus Web site answers with rhetorical tail-chasing in which “centrism” is so exalted that it justifies any position the centrist takes by virtue of the label itself. The slightly more sophisticated explanation currently in vogue with the media—the Dogs come from heartland districts where the culture wars are a big deal—helps even less.
As the syndicated columnist David Sirota pointed out last week on the OpenLeft blog, having constituents who care deeply about, say, gun rights doesn’t really have anything to do with the pro-corporate stands on mortgage modification and health insurance that have made the Blue Dogs famous.
Friday’s page-one Post story about the Blue Dogs suggests a far simpler explanation: Entrepreneurship. In addition to everything else, the Dogs are champion fund raisers. Individual Dogs do far better than garden-variety Democrats when it comes to bringing in contributions from folks with business before Congress, like the insurance industry and the medical industry. According to CQ, their political action committee is the only Democratic PAC to rival the big Republican dogs; in 2009 fund raising it has been bested only by Mitt Romney’s gang.
So this is the Blue Dogs’ day, with games of fetch down on K Street that had me reminiscing, as I read the Post’s description, about the times when Tom DeLay and his pack did their own tricks for industry’s table scraps.
My guess is that the Blue Dogs, like Jack Abramoff’s Republicans before them, are more keenly attuned than their colleagues to that force of universal goodness, the profit motive. Theirs is simply a less ferocious version of what we had before, with cuddly bipartisan righteousness replacing the fierce red-state righteousness of DeLay’s dogs. But the master is the same as ever, and surely we can still count on the profit motive to deliver the very best in public policy.
Still, there remains the problem of the senseless moniker, “Blue Dog.” In the interests of improved political nicknames, let me propose an alternative. Back in 1932, the future Illinois Sen. Paul Douglas advised progressives not to expect too much from the Democratic Party. It was, he wrote, “maintained by the business interests” as a kind of “lifeboat.” Whenever the GOP ship sprung a leak—whenever Republicans were no longer willing or able to do business’s bidding—the interests simply piled into the other party and made their escape.
The Democrats have improved considerably since those days, at least from a progressive standpoint. But there are still branches of the party willing to carry out the ancestral mission. Let’s call them what they are: the lifeboat caucus.
Germany’s Recession vs. America’s: Doing Worse, but Feeling Better
Germany’s Recession vs. America’s: Doing Worse, but Feeling Better. By Douglas J. Elliott, Fellow, Economic Studies, Initiative on Business and Public Policy
The Brookings Institution, Jul 28, 2009
The world recession that began in the U.S. is hitting Germany much harder than us, due to a collapse in world trade that has damaged an economy that Germans constantly refer to as “the World Export Champion.” Their economy will have shrunk by about 8% by the time it bottoms, whereas America’s GDP should fall less than 4% from its peak. Intriguingly, the German public and elites feel much better about their situation than Americans do about ours. The key question is whether this represents: a justified faith in a system that works well for them; government measures that delay the pain; German complacency; or some combination of these factors.
I spent a week in Germany recently meeting with dozens of policymakers, academics, journalists, and policy analysts, as a guest of the Konrad Adenauer Foundation[1], a German public policy institute. The overwhelming impression I received was of a fundamental disconnect between the horrible recession and the calmness with which the Germans were facing it. This paper will briefly explore that disconnect, but is not intended as an overall criticism of Germany and its economy. An American observer should be humble indeed in these times about giving economic advice to other countries. However, it still seems to me that the extraordinary recent decline of the German economy should foster more serious questioning than has occurred to date. There seem to be three principal factors behind the phlegmatic German reactions.
First, the public has yet to feel the pain directly and is unlikely to do so until after the Federal elections on September 27th that will determine the make-up of the new parliament. Government programs are providing major subsidies to keep redundant employees on the payroll, at substantially reduced hours. This still has some cost for businesses, but they generally do not want to lay off significant numbers of employees prior to the elections, both out of a desire to support the more business-friendly parties and because they would not wish to be singled out by the politicians in the frenzy of a close election campaign. The clear consensus of those with whom we spoke was that there would be a massive spike in unemployment starting in the Fall.
I was told that a private poll found that only 6% of respondents had felt a significant direct effect from the recession. Another 20-30% had close friends or relatives who were affected, which still left a clear majority who just were not seeing the impact. In fact, about a third of respondents did not think they would ever see significant harm to themselves or others close to them from the recession. In addition to the delayed reaction caused by the temporary unemployment measures, the level of anxiety is almost certainly reduced by Germany’s generous social safety net, which provides a considerable degree of cushioning for those who do end up unemployed.
These polling figures contrast sharply with those for American attitudes. Here, fear is widespread, in part because unemployment has risen sharply already and is poised to go higher still. We have also been struck by the housing crisis that affects tens of millions of Americans directly or indirectly and which does not plague Germany. (Germany had a massive construction bubble after Reunification. The bursting of that bubble played a major role in preventing them from following in the over-optimistic path of the U.S., the U.K., and Spain in recent times.)
Second, Germans have great faith in their overall economic model. There is a very widespread belief, across the great middle ground of the political landscape, that their “social market” system is right for Germany. The term is amorphous, but refers to a consensus approach in which business is allowed to operate in a fundamentally capitalist manner, but with high levels of taxes/social contributions and a number of operating limitations. These limitations include such things as restricted opening hours for shops and a requirement that many corporate decisions are approved by a Supervisory Board that includes union representation.
Equally importantly, Germany is justifiably proud of its prowess in exports, particularly industrial machinery and automobiles. Somewhere between 40% and 50% of Germany’s GDP comes from exports, depending on when and how you measure it. This is more than three times that of the U.S., although it is important to note that Germany is a considerably smaller country and is closely integrated with its European neighbors, who are the largest importers of German products. (If the U.S. counted sales from the Northeast to California as exports, our figure would be sharply higher than it is.) Germans view their trade surplus as a sign of virtue and the source of overseas investments that will carry the country through a future in which their aging population cuts back on output and necessarily lives more on the fruits of past labor.
Third, Germans are somewhat puzzled when pushed by outsiders to make changes to their overall model. They believe it has worked extremely well for them and consequently were resistant in the past to all but the most compelling changes when foreigners were lecturing them about rigidities in their system, even though those foreigners were then enjoying better growth and lower unemployment than Germany. Now that it appears to Germans that the advice was coming from people who have massively messed up their own systems, they are even less inclined to change. In addition, I believe that there is a sense of resignation about being able to change very much while staying consistent with the social market approach and the reality of their business systems.
The largest vulnerability of the German economy is their heavy reliance on exports. However, there is great resistance to changing this. Germans often seem to interpret the suggestion to do so as a call to do a worse job of exporting, which would indeed be a mistake. The real advice is to free up their service sector more and to reduce the disincentives to consume. If domestic consumption and the service sector grew, Germans would become less dependent on the success of their manufacturing exports.
It seems ironic to an American that Germans, generally so careful, would build an economy so exposed to a single factor. There appears to be an almost unconscious belief that since the world crisis was not their fault, there is no need to change their model. However, this ignores the likelihood that other major countries will have problems in the future. Germany will remain exposed to the mistakes of others as long as exports dominate their economy. Even a great German driver in one of their best cars is exposed to the risks posed by drunk drivers on the road, which is one reason for the many safety features built into their autos.
In sum, the German views can be over-simplified, indeed caricatured, as follows. The U.S. and the U.K. created a catastrophe in the financial system, leading to a severe recession in those countries, which then spread around the world. The global recession created an “export shock” for Germany as world trade fell by about a quarter. The effects of that one-time shock should stabilize soon, allowing Germany to find its feet and then shift to growth, albeit slow growth. The economy will be 8% smaller at the bottom, but the basic German model of export orientation and a social market will remain intact and provide a good future. It makes sense for Germany to make a few changes around the edges, such as somewhat tougher financial regulation, but there is no need to pursue anything more sweeping.
To an American ear, it sounds unreasonable to be so little inclined to examine your core assumptions at a time when your economy is suffering twice as badly as the supposedly severely mismanaged U.S. economy and your experience is significantly worse than anything since the trauma of World War II and the immediate post-war period. It does not make it any more understandable that the only other major economy suffering so badly is Japan, which has been struggling for many years to find its way economically.
Of course, the Germans could be right in their two core premises: (a) the German way of doing things provides them the right balance of security and growth over the long haul and (b) the export shock will pass soon and they will be able to gradually move back to their pre-crisis growth rates. Only time will tell.
However, if I were a betting man, I would put my money on a significantly less complacent Germany in six months to a year. By that point, the Germans are likely to have discontinued their expensive labor subsidies, given their horror of budget deficits. That horror is exemplified by a recent constitutional amendment to phase them out over time. Unemployment will have shot up by at least a million people, largely undoing one of the proud achievements of the current government in bringing unemployment down from about 5 million to well under 4 million. This unemployment shock should bring home the magnitude of the crisis to most Germans, even with the strong safety net available to protect the unemployed. All of this will be worse still if, as I fear, the rest of the world does not resume its imports of German cars and machinery as quickly as is hoped. A slowdown in consumption could hold auto purchases down more than expected and it is likely that parts of the world over-invested in industrial machinery in the recent past and will take some time to resume buying in volume.
The German economy has done extremely well in some respects, particularly in exports, and the Germans have shown an admirable thrift. However, all economic models should be re-examined periodically and a period of extreme stress such as today seems an especially good time to review one’s assumptions.
[1] The Konrad Adenaeur Foundation is closely associated with the Christian Democratic Union, the party of Chancellor Angela Merkel. However, I do not believe this created a significant bias in the messages that we heard. The meetings included a wide range of people in and out of politics and the views expressed about the economy were consistent with media accounts of German views
The Brookings Institution, Jul 28, 2009
The world recession that began in the U.S. is hitting Germany much harder than us, due to a collapse in world trade that has damaged an economy that Germans constantly refer to as “the World Export Champion.” Their economy will have shrunk by about 8% by the time it bottoms, whereas America’s GDP should fall less than 4% from its peak. Intriguingly, the German public and elites feel much better about their situation than Americans do about ours. The key question is whether this represents: a justified faith in a system that works well for them; government measures that delay the pain; German complacency; or some combination of these factors.
I spent a week in Germany recently meeting with dozens of policymakers, academics, journalists, and policy analysts, as a guest of the Konrad Adenauer Foundation[1], a German public policy institute. The overwhelming impression I received was of a fundamental disconnect between the horrible recession and the calmness with which the Germans were facing it. This paper will briefly explore that disconnect, but is not intended as an overall criticism of Germany and its economy. An American observer should be humble indeed in these times about giving economic advice to other countries. However, it still seems to me that the extraordinary recent decline of the German economy should foster more serious questioning than has occurred to date. There seem to be three principal factors behind the phlegmatic German reactions.
First, the public has yet to feel the pain directly and is unlikely to do so until after the Federal elections on September 27th that will determine the make-up of the new parliament. Government programs are providing major subsidies to keep redundant employees on the payroll, at substantially reduced hours. This still has some cost for businesses, but they generally do not want to lay off significant numbers of employees prior to the elections, both out of a desire to support the more business-friendly parties and because they would not wish to be singled out by the politicians in the frenzy of a close election campaign. The clear consensus of those with whom we spoke was that there would be a massive spike in unemployment starting in the Fall.
I was told that a private poll found that only 6% of respondents had felt a significant direct effect from the recession. Another 20-30% had close friends or relatives who were affected, which still left a clear majority who just were not seeing the impact. In fact, about a third of respondents did not think they would ever see significant harm to themselves or others close to them from the recession. In addition to the delayed reaction caused by the temporary unemployment measures, the level of anxiety is almost certainly reduced by Germany’s generous social safety net, which provides a considerable degree of cushioning for those who do end up unemployed.
These polling figures contrast sharply with those for American attitudes. Here, fear is widespread, in part because unemployment has risen sharply already and is poised to go higher still. We have also been struck by the housing crisis that affects tens of millions of Americans directly or indirectly and which does not plague Germany. (Germany had a massive construction bubble after Reunification. The bursting of that bubble played a major role in preventing them from following in the over-optimistic path of the U.S., the U.K., and Spain in recent times.)
Second, Germans have great faith in their overall economic model. There is a very widespread belief, across the great middle ground of the political landscape, that their “social market” system is right for Germany. The term is amorphous, but refers to a consensus approach in which business is allowed to operate in a fundamentally capitalist manner, but with high levels of taxes/social contributions and a number of operating limitations. These limitations include such things as restricted opening hours for shops and a requirement that many corporate decisions are approved by a Supervisory Board that includes union representation.
Equally importantly, Germany is justifiably proud of its prowess in exports, particularly industrial machinery and automobiles. Somewhere between 40% and 50% of Germany’s GDP comes from exports, depending on when and how you measure it. This is more than three times that of the U.S., although it is important to note that Germany is a considerably smaller country and is closely integrated with its European neighbors, who are the largest importers of German products. (If the U.S. counted sales from the Northeast to California as exports, our figure would be sharply higher than it is.) Germans view their trade surplus as a sign of virtue and the source of overseas investments that will carry the country through a future in which their aging population cuts back on output and necessarily lives more on the fruits of past labor.
Third, Germans are somewhat puzzled when pushed by outsiders to make changes to their overall model. They believe it has worked extremely well for them and consequently were resistant in the past to all but the most compelling changes when foreigners were lecturing them about rigidities in their system, even though those foreigners were then enjoying better growth and lower unemployment than Germany. Now that it appears to Germans that the advice was coming from people who have massively messed up their own systems, they are even less inclined to change. In addition, I believe that there is a sense of resignation about being able to change very much while staying consistent with the social market approach and the reality of their business systems.
The largest vulnerability of the German economy is their heavy reliance on exports. However, there is great resistance to changing this. Germans often seem to interpret the suggestion to do so as a call to do a worse job of exporting, which would indeed be a mistake. The real advice is to free up their service sector more and to reduce the disincentives to consume. If domestic consumption and the service sector grew, Germans would become less dependent on the success of their manufacturing exports.
It seems ironic to an American that Germans, generally so careful, would build an economy so exposed to a single factor. There appears to be an almost unconscious belief that since the world crisis was not their fault, there is no need to change their model. However, this ignores the likelihood that other major countries will have problems in the future. Germany will remain exposed to the mistakes of others as long as exports dominate their economy. Even a great German driver in one of their best cars is exposed to the risks posed by drunk drivers on the road, which is one reason for the many safety features built into their autos.
In sum, the German views can be over-simplified, indeed caricatured, as follows. The U.S. and the U.K. created a catastrophe in the financial system, leading to a severe recession in those countries, which then spread around the world. The global recession created an “export shock” for Germany as world trade fell by about a quarter. The effects of that one-time shock should stabilize soon, allowing Germany to find its feet and then shift to growth, albeit slow growth. The economy will be 8% smaller at the bottom, but the basic German model of export orientation and a social market will remain intact and provide a good future. It makes sense for Germany to make a few changes around the edges, such as somewhat tougher financial regulation, but there is no need to pursue anything more sweeping.
To an American ear, it sounds unreasonable to be so little inclined to examine your core assumptions at a time when your economy is suffering twice as badly as the supposedly severely mismanaged U.S. economy and your experience is significantly worse than anything since the trauma of World War II and the immediate post-war period. It does not make it any more understandable that the only other major economy suffering so badly is Japan, which has been struggling for many years to find its way economically.
Of course, the Germans could be right in their two core premises: (a) the German way of doing things provides them the right balance of security and growth over the long haul and (b) the export shock will pass soon and they will be able to gradually move back to their pre-crisis growth rates. Only time will tell.
However, if I were a betting man, I would put my money on a significantly less complacent Germany in six months to a year. By that point, the Germans are likely to have discontinued their expensive labor subsidies, given their horror of budget deficits. That horror is exemplified by a recent constitutional amendment to phase them out over time. Unemployment will have shot up by at least a million people, largely undoing one of the proud achievements of the current government in bringing unemployment down from about 5 million to well under 4 million. This unemployment shock should bring home the magnitude of the crisis to most Germans, even with the strong safety net available to protect the unemployed. All of this will be worse still if, as I fear, the rest of the world does not resume its imports of German cars and machinery as quickly as is hoped. A slowdown in consumption could hold auto purchases down more than expected and it is likely that parts of the world over-invested in industrial machinery in the recent past and will take some time to resume buying in volume.
The German economy has done extremely well in some respects, particularly in exports, and the Germans have shown an admirable thrift. However, all economic models should be re-examined periodically and a period of extreme stress such as today seems an especially good time to review one’s assumptions.
[1] The Konrad Adenaeur Foundation is closely associated with the Christian Democratic Union, the party of Chancellor Angela Merkel. However, I do not believe this created a significant bias in the messages that we heard. The meetings included a wide range of people in and out of politics and the views expressed about the economy were consistent with media accounts of German views
Reducing Systemic Risk in the Financial Sector
Reducing Systemic Risk in the Financial Sector. By Alice M. Rivlin, Senior Fellow, Economic Studies. Testimony: House Committee on Financial Services & Senate Committee on Banking, Housing and Urban Affairs
July 21, 2009 —
Mr. Chairman and members of the Committee: I am happy to be back before this Committee to give my views on reducing systemic risk in financial services. I will focus on changes in our regulatory structure that might prevent another catastrophic financial meltdown and what role the Federal Reserve should play in a new financial regulatory system.
It is hard to overstate the importance of the task facing this Committee. Market capitalism is a powerful system for enhancing human economic wellbeing and allocating savings to their most productive uses. But markets cannot be counted on to police themselves. Irrational herd behavior periodically produces rapid increases in asset values, lax lending and over-borrowing, excessive risk taking, and out-sized profits followed by crashing asset values, rapid deleveraging, risk aversion, and huge loses. Such a crash can dry up normal credit flows and undermine confidence, triggering deep recession and massive unemployment. When the financial system fails on the scale we have experienced recently the losers are not just the wealthy investors and executives of financial firms who took excessive risks. They are average people here and around the world whose jobs, livelihoods, and life savings are destroyed and whose futures are ruined by the effect of financial collapse on the world economy. We owe it to them to ferret out the flaws in the financial system and the failures of regulatory response that allowed this unnecessary crisis to happen and to mend the system so to reduce the chances that financial meltdowns imperil the world’s economic wellbeing.
Approaches to Reducing Systemic Risk
The crisis was a financial “perfect storm” with multiple causes. Different explanations of why the system failed—each with some validity—point to at least three different approaches to reducing systemic risk in the future.
The highly interconnected system failed because no one was in charge of spotting the risks that could bring it down. This explanation suggests creating a Macro System Stabilizer with broad responsibility for the whole financial system charged with spotting perverse incentives, regulatory gaps and market pressures that might destabilize the system and taking steps to fix them. The Obama Administration would create a Financial Services Oversight Council (an interagency group with its own staff) to perform this function. I think this responsibility should be lodged at the Fed and supported by a Council.
The system failed because expansive monetary policy and excessive leverage fueled a housing price bubble and an explosion of risky investments in asset backed securities. While low interest rates contributed to the bubble, monetary policy has multiple objectives. It is often impossible to stabilize the economy and fight asset price bubbles with a single instrument. Hence, this explanation suggests stricter regulation of leverage throughout the financial system. Since monetary policy is an ineffective tool for controlling asset price bubbles, it should be supplemented by the power to change leverage ratios when there is evidence of an asset price bubble whose bursting that could destabilize the financial sector. Giving the Fed control of leverage would enhance the effectiveness of monetary policy. The tool should be exercised in consultation with a Financial Services Oversight Council.
The system crashed because large inter-connected financial firms failed as a result of taking excessive risks, and their failure affected other firms and markets. This explanation might lead to policies to restrain the growth of large interconnected financial firms—or even break them up—and to expedited resolution authority for large financial firms (including non-banks) to lessen the impact of their failure on the rest of the system. Some have argued for the creation of a single consolidated regulator with responsibility for all systemically important financial institutions. The Obama Administration proposes making the Fed the consolidated regulator of all Tier One Financial Institutions. I believe it would be a mistake to identify specific institutions as too big to fail and an even greater mistake to give this responsibility to the Fed. Making the Fed the consolidated prudential regulator of big interconnected institutions would weaken its focus on monetary policy and the overall stability of the financial system and could threaten its independence.
The Case for a Macro System Stabilizer
One reason that regulators failed to head off the recent crisis is that no one was explicitly charged with spotting the regulatory gaps and perverse incentives that had crept into our rapidly changing financial structure in recent decades. In recent years, anti-regulatory ideology kept the United States from modernizing the rules of the capitalist game in a period of intense financial innovation and perverse incentives to creep in.
Perverse incentives. Lax lending standards created the bad mortgages that were securitized into the toxic assets now weighting down the books of financial institutions. Lax lending standards by mortgage originators should have been spotted as a threat to stability by a Macro System Stabilizer—the Fed should have played this role and failed to do so—and corrected by tightening the rules (minimum down payments, documentation, proof that the borrow understands the terms of the loan and other no-brainers). Even more important, a Macro System Stabilizer should have focused on why the lenders had such irresistible incentives to push mortgages on people unlikely to repay. Perverse incentives were inherent in the originate-to-distribute model which left the originator with no incentive to examine the credit worthiness of the borrower. The problem was magnified as mortgage-backed securities were re-securitized into more complex instruments and sold again and again. The Administration proposes fixing that system design flaw by requiring loan originators and securitizers to retain five percent of the risk of default. This seems to me too low, especially in a market boom, but it is the right idea.
The Macro System Stabilizer should also seek other reasons why securitization of asset-backed loans—long thought to be a benign way to spread the risk of individual loans—became a monster that brought the world financial system to its knees. Was it partly because the immediate fees earned by creating and selling more and more complex collateralized debt instruments were so tempting that this market would have exploded even if the originators retained a significant portion of the risk? If so, we need to change the reward structure for this activity so that fees are paid over a long enough period to reflect actual experience with the securities being created.
Other examples, of perverse incentives that contributed to the violence of the recent perfect financial storm include Structured Investment Vehicles (SIV’s) that hid risks off balance sheets and had to be either jettisoned or brought back on balance sheet at great cost; incentives of rating agencies to produce excessively high ratings; and compensation structures of corporate executives that incented focus on short-term earnings at the expense the longer run profitability of the company.
The case for creating a new role of Macro System Stabilizer is that gaps in regulation and perverse incentives cannot be permanently corrected. Whatever new rules are adopted will become obsolete as financial innovation progresses and market participants find ways around the rules in the pursuit of profit. The Macro System Stabilizer should be constantly searching for gaps, weak links and perverse incentives serious enough to threaten the system. It should make its views public and work with other regulators and Congress to mitigate the problem.
The Treasury makes the case for a regulator with a broad mandate to collect information from all financial institutions and “identify emerging risks.” It proposes putting that responsibility in a Financial Services Oversight Council, chaired by the Treasury, with its own permanent expert staff. The Council seems to me likely to be cumbersome. Interagency councils are usually rife with turf battles and rarely get much done. I think the Fed should have the clear responsibility for spotting emerging risks and trying to head them off before it has to pump trillions into the system to avert disaster. The Fed should make a periodic report to the Congress on the stability of the financial system and possible threats to it. The Fed should consult regularly with the Treasury and other regulators (perhaps in a Financial Services Oversight Council), but should have the lead responsibility. Spotting emerging risks would fit naturally with the Fed’s efforts to monitor the state of the economy and the health of the financial sector in order to set and implement monetary policy. Having explicit responsibility for monitoring systemic risk—and more information on which to base judgments would enhance its effectiveness as a central bank.
Controlling Leverage. The biggest challenge to restructuring the incentives is: How to avoid excessive leverage that magnified the upswing and turned the downswing into a rout? The aspect of the recent financial extravaganza that made it truly lethal was the over-leveraged superstructure of complex derivatives erected on the shaky foundation of America’s housing prices. By itself, the housing boom and bust would have created distress in the residential construction, real estate, and mortgage lending sectors, as well as consumer durables and other housing related markets, but would not have tanked the economy. What did us in was the credit crunch that followed the collapse of the highly leveraged financial superstructure that pumped money into the housing sector and became a bloated monster.
One approach to controlling serious asset–price bubbles fueled by leverage would be to give the Fed the responsibility for creating a bubble Threat Warning System that would trigger changes in permissible leverage ratios across financial institutions. The warnings would be public like hurricane or terrorist threat warnings. When the threat was high—as demonstrated by rapid price increases in an important class of assets, such as land, housing, equities, and other securities without an underlying economic justification--the Fed would raise the threat level from, say, Three to Four or Yellow to Orange. Investors and financial institutions would be required to put in more of their own money or sell assets to meet the requirements. As the threat moderated, the Fed would reduce the warning level.
The Fed already has the power to set margin requirements—the percentage of his own money that an investor is required to put up to buy a stock if he is borrowing the rest from his broker. Policy makers in the 1930s, seeking to avoid repetition of the stock price bubble that preceded the 1929 crash, perceived that much of the stock market bubble of the late 1920s had been financed with money borrowed on margin from broker dealers and that the Fed needed a tool distinct from monetary policy to control such borrowing in the future.
During the stock market bubble of the late 1990s, when I was Vice Chair of the Fed’s Board of Governors, we talked briefly about raising the margin requirement, but realized that the whole financial system had changed dramatically since the 1920s. Stock market investors in the 1990s had many sources of funds other than borrowing on margin. While raising the margin requirements would have been primarily symbolic, I believe with hindsight that we should have done it anyway in hopes of showing that we were worried about the bubble.
The 1930’s legislators were correct: monetary policy is a poor instrument for counteracting asset price bubbles; controlling leverage is likely to be more effective. The Fed has been criticized for not raising interest rates in 1998 and the first half of 1999 to discourage the accelerating tech stock bubble. But it would have had to raise rates dramatically to slow the market’s upward momentum—a move that conditions in the general economy did not justify. Productivity growth was increasing, inflation was benign and responding to the Asian financial crisis argued for lowering rates, not raising them. Similarly, the Fed might have raised rates from their extremely low levels in 2003 or raised them earlier and more steeply in 2004-5 to discourage the nascent housing price bubble. But such action would have been regarded as a bizarre attempt to abort the economy’s still slow recovery. At the time there was little understanding of the extent to which the highly leveraged financial superstructure was building on the collective delusion that U.S. housing prices could not fall. Even with hindsight, controlling leverage (along with stricter regulation of mortgage lending standards) would have been a more effective response to the housing bubble than raising interest rates. But regulators lacked the tools to control excessive leverage across the financial system.
In the wake of the current crisis, financial system reformers have approached the leverage control problem in pieces, which is appropriate since financial institutions play diverse roles. However the Federal Reserve—as Macro System Stabilizer—could be given the power to tie the system together so that various kinds of leverage ratios move in the same direction simultaneously as the threat changes.
With respect to large commercial banks and other systemically important financial institutions, for example, there is emerging consensus that higher capital ratios would have helped them weather the recent crisis, that capital requirements should be higher for larger, more interconnected institutions than for smaller, less interconnected ones, and that these requirements should rise as the systemic threat level (often associated with asset price bubbles) goes up.
With respect to hedge funds and other private investment funds, there is also emerging consensus that they should be more transparent and that financial derivatives should be traded on regulated exchanges or at least cleared on clearinghouses. But such funds might also be subject to leverage limitations that would move with the perceived threat level and could disappear if the threat were low.
One could also tie asset securitization into this system. The percent of risk that the originator or securitizer was required to retain could vary with the perceived threat of an asset price bubble. This percentage could be low most of the time, but rise automatically if Macro System Stabilizer deemed the threat of a major asset price bubble was high. One might even apply the system to rating agencies. In addition to requiring rating agencies to be more transparent about their methods and assumptions, they might be subjected to extra scrutiny or requirements when the bubble threat level was high.
Designing and coordinating such a leverage control system would not be an easy thing to do. It would require create thinking and care not to introduce new loopholes and perverse incentives. Nevertheless, it holds hope for avoiding the run away asset price exuberance that leads to financial disaster.
Systemically Important Institutions
The Obama Administration has proposed that there should be a consolidated prudential regulator of large interconnected financial institutions (Tier One Financial Holding Companies) and that this responsibility be given to the Federal Reserve. I think this is the wrong way to go.
It is certainly important to reduce the risk that large interconnected institutions fail as a result of engaging in highly risky behavior and that the contagion of their failure brings down others. However, there are at least three reasons for questioning the wisdom of identifying a specific list of such institutions and giving them their own consolidated regulator and set of regulations. First, as the current crisis has amply illustrated, it is very difficult to identify in advance institutions that pose systemic risk. The regulatory system that failed us was based on the premise that commercial banks and thrift institutions that take deposits and make loans should be subject to prudential regulation because their deposits are insured by the federal government and they can borrow from the Federal Reserve if they get into trouble. But in this crisis, not only did the regulators fail to prevent excessive risk-taking by depository institutions, especially thrifts, but systemic threats came from other quarters. Bear Stearns and Lehman Brothers had no insured deposits and no claim on the resources of the Federal Reserve. Yet when they made stupid decisions and were on the edge of failure the authorities realized they were just as much a threat to the system as commercial banks and thrifts. So was the insurance giant, AIG, and, in an earlier decade, the large hedge fund, LTCM. It is hard to identify a systemically important institution until it is on the point of bringing the system down and then it may be too late.
Second, if we visibly cordon off the systemically important institutions and set stricter rules for them than for other financial institutions, we will drive risky behavior outside the strictly regulated cordon. The next systemic crisis will then likely come from outside the ring, as it came this time from outside the cordon of commercial banks.
Third, identifying systemically important institutions and giving them their own consolidated regulator tends to institutionalize ‘Too Big to Fail’ and create a new set of GSE-like institutions. There is a risk that the consolidated regulator will see its job as not allowing any of its charges to go down the tubes and is prepared to put taxpayer money at risk to prevent such failures.
Higher capital requirements and stricter regulations for large interconnected institutions make sense, but I would favor a continuum rather than a defined list of institutions with its own special regulator. Since there is no obvious place to put such a responsibility, I think we should seriously consider creating a new financial regulator. This new institution could be similar to the UK’s FSA, but structured to be more effective than the FSA proved in the current crisis. In the US one might start by creating a new consolidated regulator of all financial holding companies. It should be an independent agency but might report to a board composed of other regulators, similar to the Treasury proposal for a Council for Financial Oversight. As the system evolves the consolidated regulator might also subsume the functional regulation of nationally chartered banks, the prudential regulation of broker-dealers and nationally chartered insurance companies.
I don’t pretend to have a definitive answer to how the regulatory boxes should best be arranged, but it seems to me a mistake to give the Federal Reserve responsibility for consolidated prudential regulation of Tier One Financial Holding Companies, as proposed by the Obama Administration. I believe the skills needed by an effective central bank are quite different from those needed to be an effective financial institution regulator. Moreover, the regulatory responsibility would likely grow with time, distract the Fed from its central banking functions, and invite political interference that would eventually threaten the independence of monetary policy.
Especially in recent decades, the Federal Reserve has been a successful and widely respected central bank. It has been led by a series of strong macro economists—Paul Volcker, Alan Greenspan, Ben Bernanke—who have been skillful at reading the ups and downs of the economy and steering a monetary policy course that contained inflation and fostered sustainable economic growth. It has played its role as banker to the banks and lender of last resort—including aggressive action with little used tools in the crisis of 2008-9. It has kept the payments system functioning even in crises such as 9/11, and worked effectively with other central banks to coordinate responses to credit crunches, especially the current one. Populist resentment of the Fed’s control of monetary policy has faded as understanding of the importance of having an independent institution to contain inflation has grown—and the Fed has been more transparent about its objectives. Although respect for the Fed’s monetary policy has grown in recent years, its regulatory role has diminished. As regulator of Bank Holding Companies, it did not distinguish itself in the run up to the current crisis (nor did other regulators). It missed the threat posed by the deterioration of mortgage lending standards and the growth of complex derivatives.
If the Fed were to take on the role of consolidated prudential regulator of Tier One Financial Holding Companies, it would need strong, committed leadership with regulatory skills—lawyers, not economists. This is not a job for which you would look to a Volcker, Greenspan or Bernanke. Moreover, the regulatory responsibility would likely grow as it became clear that the number and type of systemically important institutions was increasing. My fear is that a bifurcated Fed would be less effective and less respected in monetary policy. Moreover, the concentration of that much power in an institution would rightly make the Congress nervous unless it exercised more oversight and accountability. The Congress would understandably seek to appropriate the Fed’s budget and require more reporting and accounting. This is not necessarily bad, but it could result in more Congressional interference with monetary policy, which could threaten the Fed’s effectiveness and credibility in containing inflation.
In summary, Mr. Chairman: I believe that we need an agency with specific responsibility for spotting regulatory gaps, perverse incentives, and building market pressures that could pose serious threats to the stability of the financial system. I would give the Federal Reserve clear responsibility for Macro System Stability, reporting periodically to Congress and coordinating with a Financial System Oversight Council. I would also give the Fed new powers to control leverage across the system—again in coordination with the Council. I would not create a special regulator for Tier One Financial Holding Companies, and I would certainly not give that responsibility to the Fed, lest it become a less effective and less independent central bank.
Thank you, Mr. Chairman and members of the Committee.
July 21, 2009 —
Mr. Chairman and members of the Committee: I am happy to be back before this Committee to give my views on reducing systemic risk in financial services. I will focus on changes in our regulatory structure that might prevent another catastrophic financial meltdown and what role the Federal Reserve should play in a new financial regulatory system.
It is hard to overstate the importance of the task facing this Committee. Market capitalism is a powerful system for enhancing human economic wellbeing and allocating savings to their most productive uses. But markets cannot be counted on to police themselves. Irrational herd behavior periodically produces rapid increases in asset values, lax lending and over-borrowing, excessive risk taking, and out-sized profits followed by crashing asset values, rapid deleveraging, risk aversion, and huge loses. Such a crash can dry up normal credit flows and undermine confidence, triggering deep recession and massive unemployment. When the financial system fails on the scale we have experienced recently the losers are not just the wealthy investors and executives of financial firms who took excessive risks. They are average people here and around the world whose jobs, livelihoods, and life savings are destroyed and whose futures are ruined by the effect of financial collapse on the world economy. We owe it to them to ferret out the flaws in the financial system and the failures of regulatory response that allowed this unnecessary crisis to happen and to mend the system so to reduce the chances that financial meltdowns imperil the world’s economic wellbeing.
Approaches to Reducing Systemic Risk
The crisis was a financial “perfect storm” with multiple causes. Different explanations of why the system failed—each with some validity—point to at least three different approaches to reducing systemic risk in the future.
The highly interconnected system failed because no one was in charge of spotting the risks that could bring it down. This explanation suggests creating a Macro System Stabilizer with broad responsibility for the whole financial system charged with spotting perverse incentives, regulatory gaps and market pressures that might destabilize the system and taking steps to fix them. The Obama Administration would create a Financial Services Oversight Council (an interagency group with its own staff) to perform this function. I think this responsibility should be lodged at the Fed and supported by a Council.
The system failed because expansive monetary policy and excessive leverage fueled a housing price bubble and an explosion of risky investments in asset backed securities. While low interest rates contributed to the bubble, monetary policy has multiple objectives. It is often impossible to stabilize the economy and fight asset price bubbles with a single instrument. Hence, this explanation suggests stricter regulation of leverage throughout the financial system. Since monetary policy is an ineffective tool for controlling asset price bubbles, it should be supplemented by the power to change leverage ratios when there is evidence of an asset price bubble whose bursting that could destabilize the financial sector. Giving the Fed control of leverage would enhance the effectiveness of monetary policy. The tool should be exercised in consultation with a Financial Services Oversight Council.
The system crashed because large inter-connected financial firms failed as a result of taking excessive risks, and their failure affected other firms and markets. This explanation might lead to policies to restrain the growth of large interconnected financial firms—or even break them up—and to expedited resolution authority for large financial firms (including non-banks) to lessen the impact of their failure on the rest of the system. Some have argued for the creation of a single consolidated regulator with responsibility for all systemically important financial institutions. The Obama Administration proposes making the Fed the consolidated regulator of all Tier One Financial Institutions. I believe it would be a mistake to identify specific institutions as too big to fail and an even greater mistake to give this responsibility to the Fed. Making the Fed the consolidated prudential regulator of big interconnected institutions would weaken its focus on monetary policy and the overall stability of the financial system and could threaten its independence.
The Case for a Macro System Stabilizer
One reason that regulators failed to head off the recent crisis is that no one was explicitly charged with spotting the regulatory gaps and perverse incentives that had crept into our rapidly changing financial structure in recent decades. In recent years, anti-regulatory ideology kept the United States from modernizing the rules of the capitalist game in a period of intense financial innovation and perverse incentives to creep in.
Perverse incentives. Lax lending standards created the bad mortgages that were securitized into the toxic assets now weighting down the books of financial institutions. Lax lending standards by mortgage originators should have been spotted as a threat to stability by a Macro System Stabilizer—the Fed should have played this role and failed to do so—and corrected by tightening the rules (minimum down payments, documentation, proof that the borrow understands the terms of the loan and other no-brainers). Even more important, a Macro System Stabilizer should have focused on why the lenders had such irresistible incentives to push mortgages on people unlikely to repay. Perverse incentives were inherent in the originate-to-distribute model which left the originator with no incentive to examine the credit worthiness of the borrower. The problem was magnified as mortgage-backed securities were re-securitized into more complex instruments and sold again and again. The Administration proposes fixing that system design flaw by requiring loan originators and securitizers to retain five percent of the risk of default. This seems to me too low, especially in a market boom, but it is the right idea.
The Macro System Stabilizer should also seek other reasons why securitization of asset-backed loans—long thought to be a benign way to spread the risk of individual loans—became a monster that brought the world financial system to its knees. Was it partly because the immediate fees earned by creating and selling more and more complex collateralized debt instruments were so tempting that this market would have exploded even if the originators retained a significant portion of the risk? If so, we need to change the reward structure for this activity so that fees are paid over a long enough period to reflect actual experience with the securities being created.
Other examples, of perverse incentives that contributed to the violence of the recent perfect financial storm include Structured Investment Vehicles (SIV’s) that hid risks off balance sheets and had to be either jettisoned or brought back on balance sheet at great cost; incentives of rating agencies to produce excessively high ratings; and compensation structures of corporate executives that incented focus on short-term earnings at the expense the longer run profitability of the company.
The case for creating a new role of Macro System Stabilizer is that gaps in regulation and perverse incentives cannot be permanently corrected. Whatever new rules are adopted will become obsolete as financial innovation progresses and market participants find ways around the rules in the pursuit of profit. The Macro System Stabilizer should be constantly searching for gaps, weak links and perverse incentives serious enough to threaten the system. It should make its views public and work with other regulators and Congress to mitigate the problem.
The Treasury makes the case for a regulator with a broad mandate to collect information from all financial institutions and “identify emerging risks.” It proposes putting that responsibility in a Financial Services Oversight Council, chaired by the Treasury, with its own permanent expert staff. The Council seems to me likely to be cumbersome. Interagency councils are usually rife with turf battles and rarely get much done. I think the Fed should have the clear responsibility for spotting emerging risks and trying to head them off before it has to pump trillions into the system to avert disaster. The Fed should make a periodic report to the Congress on the stability of the financial system and possible threats to it. The Fed should consult regularly with the Treasury and other regulators (perhaps in a Financial Services Oversight Council), but should have the lead responsibility. Spotting emerging risks would fit naturally with the Fed’s efforts to monitor the state of the economy and the health of the financial sector in order to set and implement monetary policy. Having explicit responsibility for monitoring systemic risk—and more information on which to base judgments would enhance its effectiveness as a central bank.
Controlling Leverage. The biggest challenge to restructuring the incentives is: How to avoid excessive leverage that magnified the upswing and turned the downswing into a rout? The aspect of the recent financial extravaganza that made it truly lethal was the over-leveraged superstructure of complex derivatives erected on the shaky foundation of America’s housing prices. By itself, the housing boom and bust would have created distress in the residential construction, real estate, and mortgage lending sectors, as well as consumer durables and other housing related markets, but would not have tanked the economy. What did us in was the credit crunch that followed the collapse of the highly leveraged financial superstructure that pumped money into the housing sector and became a bloated monster.
One approach to controlling serious asset–price bubbles fueled by leverage would be to give the Fed the responsibility for creating a bubble Threat Warning System that would trigger changes in permissible leverage ratios across financial institutions. The warnings would be public like hurricane or terrorist threat warnings. When the threat was high—as demonstrated by rapid price increases in an important class of assets, such as land, housing, equities, and other securities without an underlying economic justification--the Fed would raise the threat level from, say, Three to Four or Yellow to Orange. Investors and financial institutions would be required to put in more of their own money or sell assets to meet the requirements. As the threat moderated, the Fed would reduce the warning level.
The Fed already has the power to set margin requirements—the percentage of his own money that an investor is required to put up to buy a stock if he is borrowing the rest from his broker. Policy makers in the 1930s, seeking to avoid repetition of the stock price bubble that preceded the 1929 crash, perceived that much of the stock market bubble of the late 1920s had been financed with money borrowed on margin from broker dealers and that the Fed needed a tool distinct from monetary policy to control such borrowing in the future.
During the stock market bubble of the late 1990s, when I was Vice Chair of the Fed’s Board of Governors, we talked briefly about raising the margin requirement, but realized that the whole financial system had changed dramatically since the 1920s. Stock market investors in the 1990s had many sources of funds other than borrowing on margin. While raising the margin requirements would have been primarily symbolic, I believe with hindsight that we should have done it anyway in hopes of showing that we were worried about the bubble.
The 1930’s legislators were correct: monetary policy is a poor instrument for counteracting asset price bubbles; controlling leverage is likely to be more effective. The Fed has been criticized for not raising interest rates in 1998 and the first half of 1999 to discourage the accelerating tech stock bubble. But it would have had to raise rates dramatically to slow the market’s upward momentum—a move that conditions in the general economy did not justify. Productivity growth was increasing, inflation was benign and responding to the Asian financial crisis argued for lowering rates, not raising them. Similarly, the Fed might have raised rates from their extremely low levels in 2003 or raised them earlier and more steeply in 2004-5 to discourage the nascent housing price bubble. But such action would have been regarded as a bizarre attempt to abort the economy’s still slow recovery. At the time there was little understanding of the extent to which the highly leveraged financial superstructure was building on the collective delusion that U.S. housing prices could not fall. Even with hindsight, controlling leverage (along with stricter regulation of mortgage lending standards) would have been a more effective response to the housing bubble than raising interest rates. But regulators lacked the tools to control excessive leverage across the financial system.
In the wake of the current crisis, financial system reformers have approached the leverage control problem in pieces, which is appropriate since financial institutions play diverse roles. However the Federal Reserve—as Macro System Stabilizer—could be given the power to tie the system together so that various kinds of leverage ratios move in the same direction simultaneously as the threat changes.
With respect to large commercial banks and other systemically important financial institutions, for example, there is emerging consensus that higher capital ratios would have helped them weather the recent crisis, that capital requirements should be higher for larger, more interconnected institutions than for smaller, less interconnected ones, and that these requirements should rise as the systemic threat level (often associated with asset price bubbles) goes up.
With respect to hedge funds and other private investment funds, there is also emerging consensus that they should be more transparent and that financial derivatives should be traded on regulated exchanges or at least cleared on clearinghouses. But such funds might also be subject to leverage limitations that would move with the perceived threat level and could disappear if the threat were low.
One could also tie asset securitization into this system. The percent of risk that the originator or securitizer was required to retain could vary with the perceived threat of an asset price bubble. This percentage could be low most of the time, but rise automatically if Macro System Stabilizer deemed the threat of a major asset price bubble was high. One might even apply the system to rating agencies. In addition to requiring rating agencies to be more transparent about their methods and assumptions, they might be subjected to extra scrutiny or requirements when the bubble threat level was high.
Designing and coordinating such a leverage control system would not be an easy thing to do. It would require create thinking and care not to introduce new loopholes and perverse incentives. Nevertheless, it holds hope for avoiding the run away asset price exuberance that leads to financial disaster.
Systemically Important Institutions
The Obama Administration has proposed that there should be a consolidated prudential regulator of large interconnected financial institutions (Tier One Financial Holding Companies) and that this responsibility be given to the Federal Reserve. I think this is the wrong way to go.
It is certainly important to reduce the risk that large interconnected institutions fail as a result of engaging in highly risky behavior and that the contagion of their failure brings down others. However, there are at least three reasons for questioning the wisdom of identifying a specific list of such institutions and giving them their own consolidated regulator and set of regulations. First, as the current crisis has amply illustrated, it is very difficult to identify in advance institutions that pose systemic risk. The regulatory system that failed us was based on the premise that commercial banks and thrift institutions that take deposits and make loans should be subject to prudential regulation because their deposits are insured by the federal government and they can borrow from the Federal Reserve if they get into trouble. But in this crisis, not only did the regulators fail to prevent excessive risk-taking by depository institutions, especially thrifts, but systemic threats came from other quarters. Bear Stearns and Lehman Brothers had no insured deposits and no claim on the resources of the Federal Reserve. Yet when they made stupid decisions and were on the edge of failure the authorities realized they were just as much a threat to the system as commercial banks and thrifts. So was the insurance giant, AIG, and, in an earlier decade, the large hedge fund, LTCM. It is hard to identify a systemically important institution until it is on the point of bringing the system down and then it may be too late.
Second, if we visibly cordon off the systemically important institutions and set stricter rules for them than for other financial institutions, we will drive risky behavior outside the strictly regulated cordon. The next systemic crisis will then likely come from outside the ring, as it came this time from outside the cordon of commercial banks.
Third, identifying systemically important institutions and giving them their own consolidated regulator tends to institutionalize ‘Too Big to Fail’ and create a new set of GSE-like institutions. There is a risk that the consolidated regulator will see its job as not allowing any of its charges to go down the tubes and is prepared to put taxpayer money at risk to prevent such failures.
Higher capital requirements and stricter regulations for large interconnected institutions make sense, but I would favor a continuum rather than a defined list of institutions with its own special regulator. Since there is no obvious place to put such a responsibility, I think we should seriously consider creating a new financial regulator. This new institution could be similar to the UK’s FSA, but structured to be more effective than the FSA proved in the current crisis. In the US one might start by creating a new consolidated regulator of all financial holding companies. It should be an independent agency but might report to a board composed of other regulators, similar to the Treasury proposal for a Council for Financial Oversight. As the system evolves the consolidated regulator might also subsume the functional regulation of nationally chartered banks, the prudential regulation of broker-dealers and nationally chartered insurance companies.
I don’t pretend to have a definitive answer to how the regulatory boxes should best be arranged, but it seems to me a mistake to give the Federal Reserve responsibility for consolidated prudential regulation of Tier One Financial Holding Companies, as proposed by the Obama Administration. I believe the skills needed by an effective central bank are quite different from those needed to be an effective financial institution regulator. Moreover, the regulatory responsibility would likely grow with time, distract the Fed from its central banking functions, and invite political interference that would eventually threaten the independence of monetary policy.
Especially in recent decades, the Federal Reserve has been a successful and widely respected central bank. It has been led by a series of strong macro economists—Paul Volcker, Alan Greenspan, Ben Bernanke—who have been skillful at reading the ups and downs of the economy and steering a monetary policy course that contained inflation and fostered sustainable economic growth. It has played its role as banker to the banks and lender of last resort—including aggressive action with little used tools in the crisis of 2008-9. It has kept the payments system functioning even in crises such as 9/11, and worked effectively with other central banks to coordinate responses to credit crunches, especially the current one. Populist resentment of the Fed’s control of monetary policy has faded as understanding of the importance of having an independent institution to contain inflation has grown—and the Fed has been more transparent about its objectives. Although respect for the Fed’s monetary policy has grown in recent years, its regulatory role has diminished. As regulator of Bank Holding Companies, it did not distinguish itself in the run up to the current crisis (nor did other regulators). It missed the threat posed by the deterioration of mortgage lending standards and the growth of complex derivatives.
If the Fed were to take on the role of consolidated prudential regulator of Tier One Financial Holding Companies, it would need strong, committed leadership with regulatory skills—lawyers, not economists. This is not a job for which you would look to a Volcker, Greenspan or Bernanke. Moreover, the regulatory responsibility would likely grow as it became clear that the number and type of systemically important institutions was increasing. My fear is that a bifurcated Fed would be less effective and less respected in monetary policy. Moreover, the concentration of that much power in an institution would rightly make the Congress nervous unless it exercised more oversight and accountability. The Congress would understandably seek to appropriate the Fed’s budget and require more reporting and accounting. This is not necessarily bad, but it could result in more Congressional interference with monetary policy, which could threaten the Fed’s effectiveness and credibility in containing inflation.
In summary, Mr. Chairman: I believe that we need an agency with specific responsibility for spotting regulatory gaps, perverse incentives, and building market pressures that could pose serious threats to the stability of the financial system. I would give the Federal Reserve clear responsibility for Macro System Stability, reporting periodically to Congress and coordinating with a Financial System Oversight Council. I would also give the Fed new powers to control leverage across the system—again in coordination with the Council. I would not create a special regulator for Tier One Financial Holding Companies, and I would certainly not give that responsibility to the Fed, lest it become a less effective and less independent central bank.
Thank you, Mr. Chairman and members of the Committee.
Why Revive the Cold War? - Russia and the U.S. were reducing their nuclear arsenals without ‘arms control’
Why Revive the Cold War? By DOUGLAS J. FEITH AND ABRAM N. SHULSKY
Russia and the U.S. were reducing their nuclear arsenals without ‘arms control.’
WSJ, Aug 04, 2009
The Cold War ended nearly 20 years ago. Isn’t it time we abandoned policies specifically designed to deal with it? Arms-control talks are a case in point. Why should U.S. officials act as if only a Cold War-style treaty can save the United States and Russia from a destabilizing nuclear arms race?
Despite President Barack Obama’s strange, pre-Moscow summit remark last month in a New York Times interview that the U.S. and Russia are continuing to “grow” their nuclear stockpiles, both countries have in fact reduced their stockpiles drastically since the Soviet Union disintegrated in 1991. Those reductions resulted from unilateral decisions, not from arms-control bargaining.
Thus, on Nov. 13, 2001, President George W. Bush announced that the U.S. would unilaterally reduce its “operationally deployed strategic nuclear warheads to a level between 1,700 and 2,200 over the next decade.” This was far less than the 6,000 limit allowed under the 1991 Strategic Arms Reduction Treaty (START). Russian President Vladimir Putin promptly said in December 2001 that Russia would similarly reduce its nuclear forces.
Thus, benefiting from the happy reality that the Cold War was over, each country felt free to cut its arsenal, whether or not the other committed itself to do so. The 2002 Moscow Treaty, which simply made legally binding the reduction pledges each president had already announced, was negotiated as a friendly gesture to Russia. U.S. officials did not see it as a strategic necessity, but Mr. Putin wanted formal acknowledgment that Russia retained nuclear-arms parity with the U.S., though it could no longer be seen as America’s peer overall.
Now, with START set to expire in December, it is Mr. Obama who’s intent on signing a new treaty. He says U.S.-Russian arms reductions will help stem nuclear proliferation.
Mr. Obama here is mixing up pretext and policy. When criticized for pursuing nuclear weapons, proliferators like North Korea and Iran make diplomatic talking points out of the size of the great powers’ arsenals. They try to shift the focus away from themselves by complaining that the Americans and Russians aren’t working hard enough to reach disarmament goals envisioned in the Nuclear Non-Proliferation Treaty. But depriving proliferators of such talking points won’t affect their incentives to acquire nuclear weapons—or the world’s incentives to counter the dangers that the North Korean and Iranian nuclear programs pose to international peace.
Nor would cutting the U.S. and Russian arsenals by a few hundred weapons do anything significant to achieve Mr. Obama’s goal of a world without nuclear weapons. The roadblock is the fact of U.S. dependence on nuclear deterrence. So long as the security of the U.S. and of our allies and friends requires such dependence, a non-nuclear world will remain out of reach. Inventing a way to dispense with nuclear deterrence will require a political or technological breakthrough of major magnitude. Retaining our dependence on nuclear weapons even at somewhat lower levels is an admission by the Obama administration that the proposed reductions don’t actually bring us closer to a non-nuclear world.
With Mr. Obama openly eager for a START follow-on treaty, Russian leaders have chosen to play coy and become demanding. So what might the U.S. have to pay for it? The price is likely to be high, as suggested by the “Joint Understanding” the U.S. and Russian presidents announced last month in Moscow.
Point 5 of the Understanding specifies that the new treaty is to contain “a provision on the interrelationship of strategic offensive and strategic defensive arms.” Russia will use this language (which Bush administration officials repeatedly rejected) to try to derail U.S. plans for a Europe-based missile system designed to counter Iranian missile threats. If Russia succeeds here, the new treaty would increase the value to Iran of acquiring nuclear weapons. By making it easier for a nuclear-armed Iran to threaten all of Europe and eventually the U.S., the new treaty would promote rather than discourage nuclear proliferation.
Similarly, according to Point 6, the new treaty is to contain a provision on how non-nuclear, long-range strike weapons may affect strategic stability. Russia wants this to impede U.S. development of such weapons, probably by requiring that they be counted as if they had nuclear warheads. Hence the new treaty could shut down one of the more promising avenues for reducing U.S. dependence on nuclear arms for strategic strike.
All in all, the Obama administration’s nuclear weapons policies appear confused and self-defeating. Mr. Obama seems willing to pay for arms reductions that Russian officials have made clear will occur soon, due to aging or the planned modernization of systems, with or without a new treaty. Moreover, the Obama administration is opposing modernization measures designed to protect against the risk that the aging of U.S. weapons will compromise their safety or reliability.
There is an important connection between proliferation risks and modernization. But the Obama administration seems to have it backwards. If the U.S. fails to ensure the continuing safety and reliability of its arsenal, it could cause the collapse of the U.S. nuclear umbrella. Countries such as Japan, South Korea, Taiwan, Australia and others might decide that their security requires them to acquire their own nuclear arsenals, rather than rely indefinitely on the U.S. The world could reach a tipping point, with cascading nuclear proliferation, as the bipartisan Congressional Strategic Posture Commission warned in its May 2009 report.
The Obama administration’s nuclear weapons policies—including its treaty talks with Russia—affect the way America’s friends and potential adversaries view the integrity of the U.S. deterrent. The wrong policies can endanger the U.S. directly. They can also cause other states to lose confidence in the American nuclear umbrella and to seek security in national nuclear capabilities.
If that happens, the dangers of a nuclear war somewhere in the world would go up substantially. It would not be the first time a U.S. government helped bring about the opposite of its intended result—but it might be one of the costliest mistakes ever.
Mr. Feith, a former under secretary of defense for policy (2001-05), is the author of “War and Decision: Inside the Pentagon at the Dawn of the War on Terrorism” (HarperCollins, 2008). Mr. Shulsky is a former Defense Department official who dealt with arms control issues. Both are senior fellows at the Hudson Institute.
Russia and the U.S. were reducing their nuclear arsenals without ‘arms control.’
WSJ, Aug 04, 2009
The Cold War ended nearly 20 years ago. Isn’t it time we abandoned policies specifically designed to deal with it? Arms-control talks are a case in point. Why should U.S. officials act as if only a Cold War-style treaty can save the United States and Russia from a destabilizing nuclear arms race?
Despite President Barack Obama’s strange, pre-Moscow summit remark last month in a New York Times interview that the U.S. and Russia are continuing to “grow” their nuclear stockpiles, both countries have in fact reduced their stockpiles drastically since the Soviet Union disintegrated in 1991. Those reductions resulted from unilateral decisions, not from arms-control bargaining.
Thus, on Nov. 13, 2001, President George W. Bush announced that the U.S. would unilaterally reduce its “operationally deployed strategic nuclear warheads to a level between 1,700 and 2,200 over the next decade.” This was far less than the 6,000 limit allowed under the 1991 Strategic Arms Reduction Treaty (START). Russian President Vladimir Putin promptly said in December 2001 that Russia would similarly reduce its nuclear forces.
Thus, benefiting from the happy reality that the Cold War was over, each country felt free to cut its arsenal, whether or not the other committed itself to do so. The 2002 Moscow Treaty, which simply made legally binding the reduction pledges each president had already announced, was negotiated as a friendly gesture to Russia. U.S. officials did not see it as a strategic necessity, but Mr. Putin wanted formal acknowledgment that Russia retained nuclear-arms parity with the U.S., though it could no longer be seen as America’s peer overall.
Now, with START set to expire in December, it is Mr. Obama who’s intent on signing a new treaty. He says U.S.-Russian arms reductions will help stem nuclear proliferation.
Mr. Obama here is mixing up pretext and policy. When criticized for pursuing nuclear weapons, proliferators like North Korea and Iran make diplomatic talking points out of the size of the great powers’ arsenals. They try to shift the focus away from themselves by complaining that the Americans and Russians aren’t working hard enough to reach disarmament goals envisioned in the Nuclear Non-Proliferation Treaty. But depriving proliferators of such talking points won’t affect their incentives to acquire nuclear weapons—or the world’s incentives to counter the dangers that the North Korean and Iranian nuclear programs pose to international peace.
Nor would cutting the U.S. and Russian arsenals by a few hundred weapons do anything significant to achieve Mr. Obama’s goal of a world without nuclear weapons. The roadblock is the fact of U.S. dependence on nuclear deterrence. So long as the security of the U.S. and of our allies and friends requires such dependence, a non-nuclear world will remain out of reach. Inventing a way to dispense with nuclear deterrence will require a political or technological breakthrough of major magnitude. Retaining our dependence on nuclear weapons even at somewhat lower levels is an admission by the Obama administration that the proposed reductions don’t actually bring us closer to a non-nuclear world.
With Mr. Obama openly eager for a START follow-on treaty, Russian leaders have chosen to play coy and become demanding. So what might the U.S. have to pay for it? The price is likely to be high, as suggested by the “Joint Understanding” the U.S. and Russian presidents announced last month in Moscow.
Point 5 of the Understanding specifies that the new treaty is to contain “a provision on the interrelationship of strategic offensive and strategic defensive arms.” Russia will use this language (which Bush administration officials repeatedly rejected) to try to derail U.S. plans for a Europe-based missile system designed to counter Iranian missile threats. If Russia succeeds here, the new treaty would increase the value to Iran of acquiring nuclear weapons. By making it easier for a nuclear-armed Iran to threaten all of Europe and eventually the U.S., the new treaty would promote rather than discourage nuclear proliferation.
Similarly, according to Point 6, the new treaty is to contain a provision on how non-nuclear, long-range strike weapons may affect strategic stability. Russia wants this to impede U.S. development of such weapons, probably by requiring that they be counted as if they had nuclear warheads. Hence the new treaty could shut down one of the more promising avenues for reducing U.S. dependence on nuclear arms for strategic strike.
All in all, the Obama administration’s nuclear weapons policies appear confused and self-defeating. Mr. Obama seems willing to pay for arms reductions that Russian officials have made clear will occur soon, due to aging or the planned modernization of systems, with or without a new treaty. Moreover, the Obama administration is opposing modernization measures designed to protect against the risk that the aging of U.S. weapons will compromise their safety or reliability.
There is an important connection between proliferation risks and modernization. But the Obama administration seems to have it backwards. If the U.S. fails to ensure the continuing safety and reliability of its arsenal, it could cause the collapse of the U.S. nuclear umbrella. Countries such as Japan, South Korea, Taiwan, Australia and others might decide that their security requires them to acquire their own nuclear arsenals, rather than rely indefinitely on the U.S. The world could reach a tipping point, with cascading nuclear proliferation, as the bipartisan Congressional Strategic Posture Commission warned in its May 2009 report.
The Obama administration’s nuclear weapons policies—including its treaty talks with Russia—affect the way America’s friends and potential adversaries view the integrity of the U.S. deterrent. The wrong policies can endanger the U.S. directly. They can also cause other states to lose confidence in the American nuclear umbrella and to seek security in national nuclear capabilities.
If that happens, the dangers of a nuclear war somewhere in the world would go up substantially. It would not be the first time a U.S. government helped bring about the opposite of its intended result—but it might be one of the costliest mistakes ever.
Mr. Feith, a former under secretary of defense for policy (2001-05), is the author of “War and Decision: Inside the Pentagon at the Dawn of the War on Terrorism” (HarperCollins, 2008). Mr. Shulsky is a former Defense Department official who dealt with arms control issues. Both are senior fellows at the Hudson Institute.
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