Jeremy Siegel, Ph.D. The Future for Investors

The U.S. Treasury has put out an 89-page document entitled "Financial Regulatory Reform: A New Foundation." It recommends measures that the Treasury believes would reduce the probability of a future financial crisis like the one we recently experienced.

Much about the document is good, but there are some proposals that I believe would increase economic instability and lower the competitiveness of our financial system.

The Obama administration has no reason to rush these proposals. Most of them deal with making sure that banks and other financial institutions do not get into the same overleveraged bind that was the principal cause of the current crisis.

Realistically, there is absolutely no chance of that happening in the near future. If anything, financial firms are too conservative now, which is why they are holding hundreds of billions of dollars of excess reserves and are so hesitant to lend.

With Congress tackling such huge issues as health care and the environment, as well as implementing the stimulus package enacted earlier this year, the last thing we need is a hastily created law, such as the Sarbanes-Oxley bill that followed the Enron scandal. Sarbanes-Oxley puts huge regulatory burdens on firms with minimal gains, and it did nothing to warn investors of the collapse of the financial stocks last year.

The Good

But first, the good. The Treasury wants to establish a Financial Services Oversight Council to identify firms whose failure could pose a threat to financial stability due to their size, leverage or interconnectedness.  These are called Tier 1 FHCs (Financial Holding Companies). Once the Tier 1 FHCs are identified, they would be under special regulatory supervision that involves higher capital requirements and oversight. The Council will also develop procedures to deal with these firms if they get into financial trouble.

Much of the government's actions last year seemed arbitrary, because there was no framework to take over non-bank financial firms, such as Bear Stearns, Lehman Brothers or AIG. Existing legislation deals well with the resolution of banks under the FDIC, and the government needs to develop a plan to wind down other financial intermediaries.

Some believe that no firms should be "too big to fail." But reality dictates that the government must provide some backstop for huge financial firms. Such backstops have worked for the banking industry over the past 75 years.  The Treasury proposal means that if you are Tier 1 FHC then, in return for government support, you must have stricter capital, liquidity and risk management standards.

Although some argue that this gives the Tier 1 FHCs the unfair advantage of tapping the capital market with cheap debt, my hunch is that most firms would rather stay under the government's radar rather than be subject to higher capital requirements and increased scrutiny.

Another good proposal would reduce the importance of the credit rating agencies, such as Moody's and Standard & Poor's. These agencies must share a good part of the blame for putting AAA labels on toxic assets. 

Federal and state regulators too often allow fiduciaries to use the rating agencies as a "safe harbor" when buying assets, eliminating their own responsibility for due diligence. These safe harbors give the rating agencies far too much power and, given their poor performance in the last crisis, led many fiduciaries to take inappropriate risks. The Treasury proposal calls for reducing or eliminating references to credit ratings in many regulations.

The Bad and the Ugly

But not all in the Treasury report is good.  Many proposals advocate undue interference by the government in the private sector. One bad proposal is that the government would require firms that securitize financial instruments to hold a "material portion" of the credit risk that they create. This is designed to prevent the seller from pushing bad securities into the public markets.

However, this would have done nothing to prevent the last credit crisis. In fact, Lehman, Bear Stearns and other institutions held too many of the securities that they had marketed. These firms believed they were good investments and, with short-term interest rates low, borrowed to buy more.

It is true that subprime mortgage originators took their fees upfront, notwithstanding whether the borrower defaulted or not. To link their fees to the payments by the borrower is a smart idea, but that is something that the industry can do on its own. Fees for life insurance policies are already paid in that way. There is a private incentive to get this compensation plan right, and government should not be involved.

Another unwarranted interference involves regulations regarding compensation for management and top executives of financial institutions.  The Treasury's proposals state that regulators should issue standards to "better align executive compensation practices with long-term shareholder value," and "support legislation requiring all public companies to hold nonbinding shareholder resolutions on the compensation packages of senior executive offers."

I concede that the CEOs of these large firms were seriously delinquent in monitoring the risk of their firms' investments.  And indeed part of the problem might be related to the large wealth that many were able to extract from past profits.

But getting the compensation structure right is not the job of the government.  It is clearly in the interest of firms to modify pay packages so that incentives are properly aligned. Just because the crisis indicates what firms "should have done" does not mean that the government must now mandate what "must be done."

Keep the Fed Independent

One proposal particularly disturbs me. The Treasury recommends amending the Federal Reserve Act to require the prior written approval of the Secretary of the Treasury for any extensions of credit by the Federal Reserve to individuals, partnerships or corporations in "unusual and exigent circumstances."

Let's not hamstring the Fed.  It was the Fed's emergency loans and innovative credit programs that prevented last fall's crisis from becoming a full-fledged depression. The emergency bailout of AIG's credit default swaps, as distasteful as it was, was necessary in light of the disturbances that followed the Lehman bankruptcy. The Fed's extension of credit guarantees to the money market mutual funds was also a crucial stabilizing influence. Time was of the essence, and politics should not stand in the Fed's way.

Final Words

While there are many positives in these Treasury proposals, the government should stay out of private business decisions and should not restrict the Fed's flexibility. Let's not rush through this reform. It is worth the time to get it right.