Eleven Step Financial Reform Proposal

Heizo Takenaka, who held various posts in Junichiro Koizumi’s cabinet and is now director of the Global Security Research Institute at Keio University, provides a far reaching list of financial reforms. One can quibble with his count (he describes them as 11, but items one and four are two approaches to the same issue) and some of the particulars (he suggests that regulators spend more time in the private sector, which might work in Japan, where government service is prestigious, but could simply increase regulatory capture in the US, particularly since most corporate officers would see a stint in government as a means to other ends). Nevertheless, this is a good basis for departure.

From the Financial Times:

World leaders gather on Saturday to address the global financial meltdown. They will discuss fiscal stimulus and monetary policy, and rightly so. But Japan’s bitter experience in the 1990s proves that fiscal and monetary policies are not enough. Just as important are microeconomic incentives such as rules for accounting, disclosure and compensation. Unless the micro incentives are right, the macro outcome will be wrong.

In my opinion, the global financial meltdown had less to do with macro economic errors – although such errors occurred – than with distorted and in compatible micro incentives. Here are 11 reforms that will damp the tendency of financial markets to stampede.

First, adjust capital adequacy ratios to restrain the lending cycle. For example, the 4 per cent target for the tier one capital ratio for banks might be raised to 8 per cent in booms but lowered to 3 per cent in recessions. Cycle-dependent capital ratios would reduce the tendency of banks to lend too generously in booms and too timidly in recessions.

Second, design performance benchmarks that discourage herd behaviour. Benchmarks usually reward fund managers for their performance against a reference index. Such benchmarks can trigger bubbles or stampedes. If a stock is included in the reference index and is rising, fund managers have a strong incentive to buy – even if valuations are too high already. Requiring absolute benchmarks (for example, seek 10 per cent, plus or minus 2 per cent, with a penalty for deviation in either direction) might quell the herd instinct. Relative reference indices should not be used as performance benchmarks, especially for compensation.

Third, base mark-to-market rules on the duration of liabilities. When an institution relies mostly on long-term funding, mark-to-market of assets need not be strict or frequent. Such institutions can take the long view, stabilise markets and raise returns for investors. However, when an institution relies heavily on short-term funding, mark-to-market of assets must be strict and frequent. Otherwise the capital of the institution will be vulnerable. Thus, mark-to-market rules should be based not only on the character of individual assets, but also on the duration of the liabilities of each institution.

Fourth, impose leverage limits to counter the funding cycle. In recent years, some financial institutions became overleveraged as a result of competitive pressures on regulators to lift leverage limits. Such limits should be reinstated on an internationally consistent basis. When times are good, the leverage limits should be lowered in order to prevent overshooting. When times are bad, the limits should be raised in order to spur recovery.

Fifth, expand suitability rules to all financial sectors. These protect investors from lack of information, inexperience and myopia. In the securities business, brokers must have a reasonable basis for recommending a security to a customer, in light of the customer’s circumstances. Similar rules are needed across financial institutions, especially for mortgages.

Sixth, enforce cross-country consistency. In globalised capital markets, rule changes in one country can de stabilise other countries, as shown recently by changes in deposit insurance coverage and by capital injections. Categories requiring cross-border consistency include deposit insurance, short-selling rules, money market collateral rules and leverage limits.

Seventh, mandate the exchange of personnel between regulators and regulated institutions. Too often, personnel in financial institutions fail to understand the regulators’ viewpoints and needs. Senior financial industry personnel should be required to have regulatory experience. Conversely, regulators often fail to understand the pressures and incentives in financial institutions. Moreover, regulators in one country often fail to understand rules in others. Senior regulators should be required to have market and inter national experience.

Eighth, eliminate conflict of interest in the business models of rating agencies. Rating agencies are often paid by issuers. There is therefore a temptation to give high ratings. Rating agencies may use generous assumptions or models that are biased towards an outcome that is profitable to the agency. Thus, agencies should be paid by investors, who will demand timely ratings that reflect reality, and not by issuers.

Ninth, professionalise external directors. In many cases, external directors of companies are friendly with internal board members and thus avoid making frank criticism. External board members may lack expertise in the business or independent information on which to question staff analysis. These problems could be solved by creating professional external directors, much like external auditors.

Tenth, consolidate settlement of over-the-counter trading and credit default swaps. The dispersion of OTC transactions makes it virtually impossible to follow flows. This is a particular problem in the CDS market. Regulators and investors need a better grasp of such flows to pre-empt problems. Contract standardisation is crucial.

Finally, standardise cross-border collateral agreements. Common rules are needed so that banks can pledge collateral with confidence across countries and be confident that contracts are enforceable. Absent such rules, interbank markets are more likely to freeze or stampede at the first sign of trouble.