MISSING ELEMENTS IN US FINANCIAL REFORM: THE

GRIEVOUS INADEQUACY OF THE DODD-FRANK ACT

Edward J. KaneBoston College

NORGES BANK FINANCIAL STABILITY CONFERENCEOSLO, NORWAYSeptember 2, 2010

THEME: SAFETY-NET REFORM IN THE US AND EUROPE HAS TAKEN A SIDE TRACK

1. Economically Misfocuseda) It merely expands and relocates regulatory authority and discretion

that incentive-conflicted politicians and agency leaders predictably mishandled during the securitization bubble and in its aftermath.

b) To control Systemic Risk, society must confront the predictable way that crisis management incentives and regulation-induced innovation expand safety nets in booms and redistribute income across time and income classes.

2. Politically Dishonestc) Forecasts of “Never Again” are gross exaggerationsd) No effort to clean up the dysfunctional culture of Regulatory Capture

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DFA PURPORTS TO REVERSE US SAFETY-NET GROWTH, BUT IGNORES GOVT ROLE IN CREATING IT

STUBBORN MISDIAGNOSIS OF INITIAL CRISIS: Potential Zombies’ Funding Problems Were Evidence of a Shortage of Aggregate Liquidity

SUBSEQUENT MISMISDIAGNOSIS: Crisis was caused by inexplicably defective risk management at “systemically important” firms (SIFs ≈ TDFUs)

DODD-FRANK REMEDIES: Supposes tougher rules can force SIFs to monitor and support risk exposures

• Toughen capital requirements formula• Restrict executive compensation , derivatives trading, etc.• Redefine authority and reach of financial regulators:

1. Propose to monitor “systemic risk” without agreeing on an operational and observable metric

2. Create new Financial Stability Oversight Council to contain systemic risk in the future

ISSUE IS DESUPERVISION, NOT DEREGULATION

The effectiveness of any regulatory plan depends on the vigilance and conscientiousness of incentive-conflicted private and public supervisors and watchdogs.

Moral fiber and better information are needed to overcome pressures that have forced officials into scary games of chicken that they have lost repeatedly in the past. Main Sources of incentive conflict:• Recruiting for Connections vs. for Expertise & Character • Information Blockages: finesse obligations for truth telling about

safety-net subsidies that should fall on “banks” and agencies to enable effective outside Monitoring

• Toleration of Enticements associated with Campaign Contributions and Post-government revolving-door compensation

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DFA NEGLECTS INCENTIVES THAT LEAD AGENCIES TO TOLERATE REGULATION-INDUCED INNOVATION

Financial Stability

OversightCouncil

TO FIX THINGS PROPERLY, AUTHORITIES NEED TO ASSIGN BLAME HONESTLY AND ANSWER TWO QUESTIONS CORRECTLY:

I. WHY AND HOW DID SECURITIZATION BECOME INCENTIVE-INCOMPATIBLE?

II. WHAT IS “SYSTEMIC RISK” AND HOW CAN WE MEASURE IT?

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Qn. I. HOW DID SECURITIZATION LOSE INCENTIVE COMPATIBILITY?

ANS. BY MARRYING INVESTORS’ AND REGULATORS’ NAIVE TRUST IN THE REPUTATIONAL BONDING OF KEY FIRMS TO THE CYNICAL CASINO ETHICS OF THEIR EMPLOYEES.

PRIVATE & GOVERNMENT SUPERVISORS SHUT THEIR EYES: a)TO EFFORTS TO DISGUISE LEVERAGE and b)TO VOLUME-BASED COMPENSATION SCHEMES THAT

REINFORCED THE SHORT-CUTTING AND OUTSOURCING OF DUE DILIGENCE IN SYNTHETIC CREDIT TRANSFERS

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FAILURE LAY NOT IN RULES BUT IN SURVEILLANCE

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SURVEILLANCE IS KEY BECAUSE SAFETY NETS LACK VISIBILITY IN GOOD TIMES

Major Symptom of any impending crisis is the unacknowledged proliferation of Zombie institutions in the Financial Sector. Dodd-Frank Act does not require observable evidence of net’s growth to reach the public.

Crisis-Management Instincts Compound the growth: It is as unconscionable as it is predictable for authorities and industry CEOs to assert that lending money to Zombies and guaranteeing or extending their debt capacity is an efficient way to end a crisis.

Qn. II: SYSTEMIC RISK CAN BE LIKENED TO A DISEASE WITH TWO SYMPTOMS. 1. Official definitions focus on primary symptom: the

extent to which authorities and industry sense a potential for substantial “spillovers” of defaults across leveraged financial counterparties and from these defaults to the real economy. Sources are: a) exposure to common risk factors(e.g., bad loans) and b) debts that institutions owe to one another.

2. Important 2nd Symptom: Ability of actual or potential zombie institutions to command implicit and explicit life support from national safety net: Authorities give them a subsidized“Taxpayer Put.”

INCENTIVE CONFLICT FEEDS OFFICIAL MYOPIA AND LEADS CENTRAL BANKS TO RESCUE “SYSTEMICALLY

IMPORTANT” ZOMBIE FIRMS AND COUNTRIES FROM CONSEQUENCES OF AGGRESSIVE RISK MANAGEMENT

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TAXPAYER HAS BECOME THE SUCKER IN A RISK-TRANSFER GAME: DODD-FRANK ACT IS INADEQUATE BECAUSE IT FAILS

TO GIVE TAXPAYERS AN EVEN BREAK

• A LAYERED BREAKDOWN OF PRIVATE MARKET DISCIPLINE AND GOVERNMENT SUPERVISION allowed Risk Managers at protected firms skillfully to extract safety-net subsidies: Regulation-induced innovation misrepresented and masked SIF leverage and interest-rate risk.

• Counterparties didn’t object and Safety-Net Officials did not adapt their surveillance systems dialectically to counter these moves. Lacked INCENTIVES to do this.

• Incentive conflicts 1) fueled the securitization bubble, 2) aggravated the crisis by preventing the haircutting of the creditors of DFU zombie institutions, and 3) made it difficult for authorities to FORCE prepackaged bankruptcies of politically powerful & complex Financial Holding Companies.

NO WORRIES? AS LONG AS TAXPAYERS CAN ABSORB INDUSTRY LOSSES

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REFRAMING THE POLICY PROBLEM: How Can Society Incentivize and Monitor Private and Public Managers of

National Safety Nets So that They Do NOT Encourage Subsidies to flow to Firms that Actively Expand Their

Risk-Taking and Political Clout in Clever Ways

Start by identifying Incentive Conflicts officials face: —Horizons (Obsession with near-term effects)—Multiple Principals for Top Officials—Asymmetric and Uncertain Information—Ethics: Lack of Accountability for Suppressing

Information and for Tradeoffs made between Fairness to Taxpayers and Other Objectives

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Damage Policymakers Claim to Have Spared Us Lacks an Accountable Metric

• Macroeconomic models assume identical individuals and selfless policymaking. Instead of developing an observable ‘index of bailout benefits,” officials ask us to assume that they optimize safety-net benefits & costs and then profess not to understand why citizens are angry about the distributional effects of safety-net policies.

• Start of a Remedy: Officials and managers of protected institutions should be made accountable to taxpayers for reporting and optimizing the equity-like loss exposures they shift to society. Taxpayers represent an undercompensated and under-informed stockholder class in DFU institution.

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PATH FORWARD: Goal must be to define observables that can help society to enforce duties of loyalty, competence, and care that

agents and principals implicitly owe one another.

In firms and in government, Supervisors owe five common-sense duties to their principals:

1. A duty of vision: They should continually adapt their surveillance systems to counter innovative regulatee efforts to disguise their rulebreaking;

2. A duty of prompt corrective action: They should stand ready to propose new rules and to discipline rulebreakers whenever a violation is observed;

3. A duty of efficient operation: They should produce their services at minimum cost and distributional disruption;

4. A duty of conscientious representation: They should resolve conflicts fairly, plan and train for crisis, and be prepared to put the interest of the less-informed principals ahead of their own.

5. A duty of accountability: They should make themselves answerable for neglecting or botching their duties. (Issue for CROs and monoline insurers is to bond the quality of their performance in a meaningful way.)

MEASURING SYSTEMIC RISKTo Keep Track of Developing Problems, First Step is for National

Officials to Commit to Making Use of Operational Metrics for estimating the evolving market value of the Taxpayer Put and Reporting This Value Regularly to the Citizenry. A Second Step is to Internationalize this effort.

Ethically, Institutions and Regulators ought to Acknowledge that Protected Institutions owe taxpayers information about the value of taxpayers’ stake in leveraged risk-taking because the safety net converts taxpayers into equity investors in DFU firms.

A growing Literature shows that Interval Estimates of the TAXPAYER PUT can be constructed jointly by Firms and Regulators from Data on: Stock Prices; Credit Spreads; CDS Spreads; Equity Spreads.

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Key Defect Concerns Duty of Accountability: We need a Better Incentive Structure for private and government supervisors

• In principle, perfectly selfless supervisors would bond themselves to disclose enough information about their decisionmaking to allow outsiders and agency Inspectors General to hold them politically and financially accountable for neglecting or abusing their responsibilities.

• In practice, institutional arrangements and oaths of office do not hold CROs and other safety-net supervisors accountable for detecting safety-net subsidies or minimizing the costs and adverse redistributional effects authorities engender in resolving incentive conflicts.

• To maximize accountability for these tasks, I would locate bureaucratic responsibility for measuring the taxpayer put completely outside the span of the regulatory agencies responsible for taking action to affect this value. DFA ‘s FSOC and OFR fail to effect such a separation.

• To help top regulators be better able to withstand inappropriate regulatee pressure, Financial Regulation also needs to be made into a more cleverly compensated and more prestigious profession. A high-profile international academy for financial regulation could help in this task.

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Therapeutic COCKTAIL of Targeted Actions Could Strengthen the Odds of More Dutiful Supervision

PUBLIC SECTOR REFORMS1. Improve Public-Service Contracting: Reshape Incentives and

Flow of Observable Information to confront regulation-induced innovation and to offset pressures from the industry (e.g., by measuring subsidies, by stiffening fiduciary elements of oaths of office, by creating a high-profile Academy for financial regulators, by deferred compensation and by requiring agencies to report fully on nonpublic interactions with Congress)

2. Create an independent agency tasked only with monitoring and publicizing safety-net subsidies

3. Issue Creative Treasury Instruments: With Payoffs Tied to Safety-Net Expenditures or Bailout Actions

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PRIVATE SECTOR REFORMS

1. Recognize and Accept that Firms Owe Disclosure Obligations To Taxpayers for Safety-Net Benefits.

2. Extend Liability for Financial-Institution Stockholders (esp. for top managers)

3. Disaster Planning: require managers to prepare, update, file, and rehearse with supervisors a standby plan for handling their firm’s possible bankruptcy (i.e., a workable unwinding plan) every year.

4. Extend Liability for Institutional creditors (require issuance of debt instruments with mandatory conversion to equity and/or that prescribe an automatic writedown of the recoverable amount if the firm fails)

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Politicians and Lobbyists Hope to Convince us that Genuine Reform is Beyond Society’s Reach

It is Overly Cynical and Self-Defeating to Dismiss Difficult Informational and Incentive Reforms Out of Hand

• Toughness, Training, & Commitment to Mission We demand of Firefighters, Police Officers, Soldiers, Emergency-Room Attendants, and Nuclear Safety Personnel Contrasts Badly with the Counterproductive Recruiting, Motivation, Entitlements, and Behavior Society accepts from its Elected Politicians and the Top Regulators these pols choose to appoint (e.g., Timothy Geithner).

• Strengthening training and recruitment would be the goal of a High-Profile International Academy for Financial Regulators

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