Henry Kaufman Proposes a New Regulator for Uber Banks

Henry Kaufman, aka Dr. Doom in his heyday as Salomon’s chief economist when the firm was at the peak of its power, argues in “Finance’s upper tier needs closer scrutiny,” that the very biggest financial institutions need a regulator with the savvy and reach to supervise them effectively. Kaufman put the number at roughly the top 15 in the US; this would represent a broader universe than what the Bank of England called “large complex financial institutions” (16 globally made the cut).

Some readers have taken umbrage at earlier remarks by Kaufman on the regulatory front, noting that he is on the board of the awfully-close-to-edge Lehman. Let me take issue with that view. If Lehman were private and Kaufman were on its management committee, the criticism would be well founded. But public boards are an odd beast. Operational decisions are explicitly the preserve of management. The board’s duties are limited to matters such as hiring and setting compensation for the CEO, making sure there are adequate succession plans, setting broad policies. Thus a board member might express concern about undue risk-taking, but his only remedy if he felt his concerns were ignored would be to fire the CEO (which would require the support of other board members) or quit.

Interestingly Kaufman’s article spends a great deal of time on the boards, He sees the new supervisor as playing an important role in improving the competence of directors (!) and in emboldening them in asking tough questions (although the good doctor does not put it that baldly, it’s the drift of his recommendations). The fact that Kaufman suggests that supervisors meet with board members about their duties has another implication of which he is no doubt aware but did not spell out: the fact that the directors would have a relationship with the top supervisor would give boards more leverage in dealing with management.

From the Financial Times:

The performance and behaviour of leading participants in our financial system must be improved if we are to avoid future calamities. What is urgently needed, as I have proposed for decades, is a new kind of institution we can provisionally call the Federal Financial Oversight Authority. This regulatory body would oversee only the largest US-based financial institutions – the giant conglomerates engaged in a broad range of on and off-balance sheet activities. It would monitor and supervise these conglomerates – assessing the adequacy of their capital, the soundness of their trading practices and their vulnerability to conflicts of interest as well as other measures of their stability and competitiveness.

I am not proposing comprehensive supervision of most or all financial institutions, but rather of the upper-tier players. In the US, the 15 largest institutions have combined assets of $13,000bn. They dominate many areas of trading, underwriting and investment management. Several command leading positions in derivatives and in the esoteric financial instruments that have grown so rapidly. The current regulatory and supervisory authorities should remain in place for smaller financial institutions. But assuring the soundness of the dominant companies would go a long way towards preventing systemic risks, even if smaller institutions occasionally failed.

The new authority should be a bipartisan body operating under the auspices of the Federal Reserve. The FFOA chairman also should serve as a voting member of the federal open market committee in order to bring valuable input about the well-being of the largest private institutions. Members of the FFOA should possess recognised expertise across a broad range of financial services. Finally, the chairmen of the Fed board and the FFOA should co-sign an annual report to Congress on the safety and soundness of the institutions under their purview.

Other leading economies should be encouraged to consider a similar approach. Such institutions would be effective if they supervised the functions of only the top five to 30 financial conglomerates in each country. That more consolidated and rigorous oversight might be limited to the largest financial institutions in the European Union, Canada and Japan. Moreover, because of the transnational reach of many financial conglomerates, FFOAs would need to co-operate closely. Unified supervision is essential.

One main focus of the new authority should be the training and competence of board members in financial corporations. Qualifications should include a better than working knowledge of accounting as well as competence in quantitative risk analysis techniques and proficiency with information technology. The information that reaches directors should be detailed and forthright. Directors need to be educated about transactions with affiliated companies and about transfers of assets and debts to special-purpose entities in order to achieve “off balance sheet” treatment.

New board members should be required to meet representatives of the supervisory organisation. Through these meetings, new directors should be informed of their responsibilities from the perspective of the supervising authorities. These authorities should also meet the board periodically to review the results of examinations and to be assured their recommendations are understood and will be followed. Independent directors should have separate, periodic meetings chaired by the designated lead director, with outside legal counsel present. These meetings should be guided by prepared agendas that address critical issues including the company’s risk policies, growth aspirations and succession planning.

Today’s compensation packages often favour aggressive risk-taking. Instead, managers in leading financial companies should be compensated on the basis of the long-term and sustainable profits. This can be achieved in several ways. Stock option awards should have long maturities. They should be exercisable not on termination of employment but years after termination. Contractual cash settlements on employment termination should not be paid on termination; they should be paid out later and include claw-back arrangements.

Finally, I urge that supervisory organisations be made responsible for issuing credit ratings for the institutions under their supervision. I doubt that the private rating agencies can obtain enough information – especially about large, integrated conglomerates – to enable them to render meaningful and timely ratings. The Fed already rates quite a few of the institutions under its supervision. It is called a “Camel rating,” taking the first letters from capital, assets, management, earnings and liquidity. The new authority should be charged with a similar task rather than outsourcing the function to private agencies.