Monday, March 22, 2010

Banking Reform Checklist

With health insurance reform, I was blissfully unaware of the issues for a long time, existing comfortably within the warm and comfy incubator of employer-sponsored group insurance. It was only when I was thrust out from that womb-like environment that I saw the ugly pustules in our healthcare system.

Banking is different: I lived it (or at least worked it) for many years, and I saw the warts from the inside. So, I'd humbly say I know pretty well what needs to be done to properly seal up this critical, cracked pillar of our economy. The reader is encouraged to use the following as a checklist to evaluate any legislative proposals for their adequacy.

First, a single entity must be responsible for identifying those private institutions--banks, insurance companies, processors, trade associations, exchanges, etc.--which are critical components of the financial system. They must be US-licensed and be subject to regular independent audits, and all their assets and liabilities must be visible to that regulatory entity. The Federal Reserve being that entity would make sense.

Next, all those critical institutions should be required to have filed, at all times, a "business liquidation plan" in the event of their sudden economic collapse, just as they make business continuation plans for contingencies like computer failure, natural disaster, or act of war. If they were required to identify how their equity and capital could disintegrate, and what would be done with the remaining shards of their business, it would have a sobering effect which would make real to their directors or owners that they are no longer viewed as "too big to fail" and would make their actual collapse much less likely. Significant changes in the asset or liability makeup of the institution should be immediately reflected in the liquidation plan, with appropriate criminal and civil penalties for omissions.

Safety and soundness is actually a different regulatory issue, which should be done by a different organization. The task of supervising potential liquidation of all these institutions requires extreme detachment and disbelief; helping banks to do things to stay alive is a more supportive role, and should ideally be done by an arm of the institution, such as today's FDIC, which will be on the hook to cover the bank's assets (actually it's mostly the liabilities, but I like the sound better the other way) if things go bad. It should still have the hammer--we'll shut you down if you don't raise those reserves/stop making that kind of loans, etc.--but it should be more like "we'll make you stop because we want you to survive".

On consumer protection, the point is not to restrict legal practices more; there are plenty of legal prohibitions, and the basic principle of contracts--that both parties should be able to enter into contracts when the terms are fully disclosed--should be honored. There has been considerable progress in making disclosures to consumers better. The objective should be that there is a potent--even feared--government unit which will listen to consumer complaints and act against unfair practices. That unit should also have a pure enforcement component to shut down, and apply criminal or civil penalties, to lenders, collection agencies, insurers, etc. that do not habitually operate their business according to the laws.

I do not generally favor strict limitations on interest rate lenders can charge--that just eliminates segments of the population from having access to credit. (This includes "subprime" mortgages, which should not be banned.) Of course, there are common-sense boundaries to what lenders may be permitted: if they are charging 10% a month, they are going to have to use leg-breakers to enforce those kinds of terms. Otherwise, the rules should be: you must reserve properly for the risk you take on, and you must keep some portion of all the assets--loans, or insurance policies--you book. The percentage should in all cases be significant, but they might vary to allow low retention percentages for low-risk, "conforming" mortgages and other properly secured loans. Allowing sale--without recourse, except in case of negligence or fraud--helps keep our credit grantors liquid, which is necessary to keep business going, but this business of book, sell, and walk away must end.

Then, there are a few measures I've called for in the past: credit rating agencies' business model has been exposed for a fraud; it must be revised (to be paid for by the buyer, not the seller), or they must take on some of the risk of their bad evaluations, or they should be replaced by a government agency that will do the job with rigor and integrity.

Banks should be "encouraged"--that is, squeezed--to become either investment banks or custodians of public funds, but not both, by a revision of reserve requirements which penalizes such a mix of assets beyond the level which each class would require.

Complex derivatives should be traded on transparent markets, or prohibited. Derivatives that require secrecy for their purpose should not be allowed for publicly-regulated utilities.

Hedge funds have been unfairly advantaged over mutual funds and equity investments based overseas; the rules which attempt to prevent Americans owning such investments should be relaxed, as they are an arrogant assertion of extraterritoriality (pretending we have jurisdiction over peoples' actions outside our borders).

Finally, the mortgage industry's risk management (and account servicing) techniques are immature. The huge edifice of equity in homes, comprising the largest share of Americans' savings, rests upon three poorly-poured foundation elements: a naive assumption of steadily rising home prices, the perceived benefit of the mortgage interest deduction, and simple rules of thumb in credit granting and treating troubled loans. The first has been permanently shaken and lies in ruins; the second, though politically (and economically) impossible to repeal anytime soon, should begin to be phased out in the near future (just as credit card interest's deduction was phased out some 20 years ago); and the rules, while useful for establishing the terms of securitization and FNMA/FHA guarantees, have proven inadequate as a basis for downstream management of accounts. Mortgage grantors need to monitor better the real estate values of properties they "own" (and they should own more of them) and more proactively and efficiently use a broad array of account management techniques (refinancing and restructuring offers, temporary payment holidays, structured cash management and renovation assistance, etc.), all designed to prevent unfavorable foreclosures--the economic cost of which, to lender, borrower, and community--have become too familiar during the ride through this Great Crater.

I will evaluate proposals against this lengthy checklist. My first impression is that Barney Frank's House legislation is closer to the mark (although its range is too limited), and that Chris Dodd's desperate attempts to placate Senate Republicans was both unsuccessful (in getting their support) and terribly weak in its power and scope.

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