Landmark financial markets regulation, the subject of heated debate in the U.S. Senate at press time, went through a similar process in the House of Representatives, which passed its bill last December. The prime mover behind that measure is Barney Frank (D-Mass.), chairman of the House Financial Services Committee. In this May interview with Treasury & Risk senior contributing editor Richard Gamble, Congressman Frank shares his views on the goals of reform, the process of getting there, and what it means for corporate finance, as well as the roles of the Troubled Asset Relief Program, the Federal Reserve, the Securities and Exchange Commission, the Commodity Futures Trading Commission and the Federal Deposit Insurance Corp.
Q: What elements of reform will help corporate treasurers manage counterparty risk?
A: Making sure their counterparties take less risk should help them, but they'll have to do more of their own due diligence and rely less on rating agencies. The root of the problem was bad credit quality. When you can securitize and sell off 100% of the loans you make, you don't worry enough about credit quality. There is a risk retention requirement in the legislation that will make the lenders keep some skin in the game.
Banks and dealers will also face higher capital requirements. AIG was the counterparty from hell because they didn't have to hold capital to back up their credit default swaps and credit insurance. Reform will require every financial entity to have a regulator. Credit default swaps were flying under the radar. Regulators could not see what was there. Soon they will all have to be reported and many of them will have to trade on exchanges.
Q: How serious was the threat of a financial meltdown?
A: After Lehman failed, [Federal Reserve Chairman Ben] Bernanke and [Treasury Secretary Henry] Paulson thought the world was about to end. Bernanke on his own put $80 billion into AIG. Then they came to us to authorize TARP funds. We were well on our way to a total collapse.
Q: How well did the bailout work?
A: We avoided total disaster and started a recovery. TARP will end up costing the taxpayer well under $100 billion. The biggest mistake was that we didn't do more to prevent mortgage foreclosures. More TARP money should have been spent there.
Q: How is reform addressing too-big-to-fail?
A: No company will be too big to fail. Paulson complained that with AIG and Lehman Brothers, he had to pay all or none of their debts. So he paid none for Lehman and all for AIG. Our bill would make it harder for financial companies to fail by requiring them to have more capital, retain more risk and stop the derivatives shenanigans. When that doesn't work, the law would allow regulators to step in and put nonbank financial institutions out of business, but they could only intervene as part of the death process. Wachovia and Washington Mutual were banks, so they had a path to non-disruptive failure. They failed and their shareholders were wiped out. Soon all financial institutions will have that path, and nobody will be too big to fail.
They may still be too big to fail without unacceptable consequences, and the regulators might have to deal with those consequences, but the institutions would fail. By preventing overleveraging, we'd be better able to deal with those consequences.
Q: Was weak regulation or weak enforcement more to blame for the problems?
A: Weak regulation. There were no rules around credit default swaps. Enforcement was flawed, but the bigger problem was that the rules were not there. Enforcement will never be perfect. The tougher the rules, the less you have to depend on superb enforcement.
Q: Did you hear from corporate treasurers as you were crafting the House bill?
Q: Did you hear from the Coalition for Derivatives End-Users?
A: They made the case for a legitimate need to hedge and that we should treat hedgers differently than speculators trading derivatives for profit. So we created an exemption that I think is too broad. I favored a provision that end users would not be exempt if they put the dealer counterparty in jeopardy, but we lost that one on the floor. I'm closer to the exemption language that the Senate is considering. I think we should allow the SEC and CFTC to impose capital requirements on end users if they think it's needed.
Q: Should treasurers expect to pay more for banking services if banks have to provide more capital or collateral or operate on a smaller scale?
A: No. The mechanisms we're putting in place should reduce the cost of derivatives. With transparency and exchange trading, banks would no longer be as free to charge whatever they want.
Q: In retrospect, how successful or damaging was the deregulation of financial institutions?
A: The SEC allowing companies to set their own leverage requirements was a mistake. The biggest mistake was not regulating subprime mortgages. Congress authorized it, but [Fed Chairman Alan] Greenspan refused to do it. We had good statutes but poor enforcement.
Q: If you tighten regulation of U.S. financial firms, won't the business move offshore?
A: We're working closely with other developed countries to coordinate our efforts. I've had meetings with Canadian and European Union officials. We'll pass laws individually, but they will be similar. If a rogue state tries to set up an avoidance haven, we mandate that the Fed and Treasury would punish that state. They would be denied access to our financial systems.
Q: How would you fix the incentives that reward people for taking too much risk?
A: We're mandating that the regulators get involved in compensation practices. We would require say-on-pay for every public company--it wouldn't be binding, but it would have to be on the proxy. We'd empower the regulators to disallow any perverse incentive. The Fed and FDIC are already working on this. Every financial institution would have a regulator. If the investment banks reconvert away from their commercial bank charters, the SEC would have the same authority to prevent bad compensation arrangements.
Q: What kind of bill do you expect to emerge from the reconciliation process?
A: It's unwise for me to speculate on that.
Q: Will you speculate on the end result?
A: The President will sign a very good bill before July 4.
For additional information on what the legislation might mean for finance departments, see More Viewpoints
on Financial Reform.