OPINION
Let's Try Market-Oriented Market Reform
By BERT ELY
May 31, 2008
The demands for more government regulation of financial markets are growing louder and more insistent in the wake of the housing meltdown. Treasury Secretary Henry Paulson, for example, wants Congress to give the Federal Reserve broad new powers to monitor the financial markets so that it can quickly identify new threats to financial stability when and if they emerge.
But it is naive to expect the Fed to be an omniscient predictor of financial trends. It is even more naive to think that the Fed would have the political will, and clout, to neutralize potentially destabilizing forces before they cause financial havoc.
The mess in the financial system today is the result of previous government rules that pushed markets in the wrong directions. To prevent another crisis we need to change the rules, aligning the incentives of financial players with optimum market outcomes. Here are some key changes:
- Scrap the antiquated leverage-ratio requirement for bank capital. It does not reflect the riskiness of bank assets, forcing banks to hold too much equity capital against low-risk assets, such as prime-quality mortgages. That capital burden needlessly incentivizes banks to securitize low-risk assets.
Securitization distances a bank from the consequences of bad lending and not charging enough for credit risk. Like the rest of the world, U.S. regulators should rely solely on risk-based capital requirements, reducing the incentive U.S. banks now have to sell the mortgages they originate.
- Encourage banks to use "covered bonds" to fund – and hold onto – the fixed-rate mortgages they originate. Widely used in Europe, covered bonds have longer maturities than bank deposits and are on-balance-sheet liabilities. For example, a bank might sell $2 billion of five- and 10-year covered bonds secured at all times by $2.1 billion of high-quality mortgages and other assets. Those longer maturities would reduce maturity mismatching, which was the underlying cause of the U.S. S&L fiasco and more recent problems in the financial markets. The FDIC has begun to look more favorably upon covered bonds, but far too cautiously.
- Eliminate the double taxation of corporate dividends. This raises the cost of equity capital relative to debt, encouraging financial institutions to use excessive leverage to offset the high cost of equity capital. It also tilts banks toward securitizing assets into trusts not subject to the corporate income tax.
- Modify fair-value accounting rules. Presently, financial firms must write down the value of mortgages and securities they own to supposed market values, even when markets have ceased to function.
These write-downs reduce a firm's net worth, which raises doubts about its solvency, causing its lenders to refuse to roll over the firm's maturing liabilities. Affected firms must then sell assets to pay off those liabilities, further depressing prices and accelerating a downward spiral toward widespread insolvencies among financial intermediaries.
This valuation problem can be solved by not applying fair-value accounting to those assets which have been funded by debt matching the maturity of the assets. When assets and liabilities have roughly the same maturities, changes in their market values largely cancel each other, making fair-value accounting pointless. Instead, investors will focus on valuing the net interest income produced by the assets and the liabilities financing those assets.
- Hold bond-rating agencies more accountable for their ratings. These agencies have successfully invoked the First Amendment to protect themselves against lawsuits when their ratings have been wildly wrong. Eliminating that protection when a securities issuer has paid for a rating would make the agencies extremely reluctant to rate complex, opaque securities whose performance is subject to nearly incomprehensible variables.
In short, instead of having the Fed or other regulators try to better referee a game played under badly conceived rules, Congress should change the rules.
Mr. Ely is principal of Ely & Company, Inc.
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