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Some Unanswered Questions on Financial Reform

By / 12.9.2009

The Rep. Barney Frank (D-MA)-authored Wall Street Reform and Consumer Protection Act passed the House Financial Services Committee last Wednesday, and could come to a floor vote in the House as soon as this week. Through legislative jujitsu on Frank’s part, the bill will have a lead on Sen. Chris Dodd’s (D-CT) efforts in the Senate.

The day after the committee passed the legislation, I saw Rep. Ed Perlmutter (D-CO) talk about it at an event hosted by the National Journal and got to exchange a few words with him on the subject. He was positive about the bill and its chances in the House (it will likely pass easily), and gave positive marks to the administration’s handling of the crisis in its first year in office.

But while Perlmutter said he felt the House has done its part to address regulatory reforms, I thought some of the accomplishments he touted leave unanswered fundamental questions raised by the financial crisis.

He spoke about the legislation’s planned Financial Stability Council, that would provide a forum for regulators like the Fed to address systemic risk. But the Financial Stability Council, instead of facilitating coordination among regulators, won’t live up to expectations — much like what happened with the Director of National Intelligence (DNI) that was supposed to facilitate information-sharing in the intelligence sector, but has had limited effectiveness in getting different agencies to talk to each other. The weak mandate of a Financial Stability Council would lead to regulator shopping by financial institutions, a temptation that can lead to problems similar to those seen in the case of under-regulated AIG. Moreover, the resolution authority that the council would have is useful only after the fact — it would not preemptively deal with the Too Big To Fail problem we still face.

Fixing Mark-to-Market Requirements

More generally, however, Perlmutter mentioned two ideas the House is considering that could actually contain the seeds of our next crisis.

One idea is extending the Financial Accounting Standards Board’s (FASB) loosening of mark-to-market requirements for financial institutions to value their securities. Perlmutter wants to suspend mark-to-market and make permanent the FASB’s contentious April decision to ease mark-to-market rules.

The rule would let the Financial Stability Council order FASB to suspend mark-to-market in cases where there is no market in a security or securities are being sold in a “fire sale” or distressed environment. More worrisome, however, is that banks get to declare whether the market in the securities they are holding is distressed or not. Banks can drive a truckload of bad investment decisions through this loophole without having to disclose them on their bottom line or affecting capital requirements. Under this new rule, banks will have no incentive to conduct diligent analysis of the securities they hold — anything that turns out to be worthless (like bonds backed by subprime loans) can just be called “distressed.” This would decrease transparency and not restore confidence to the system.

But mark-to-market does have the bad consequence of increasing volatility in bank balance sheets. During crises like last year’s, banks can even perversely see mark-to-market improve their bottom line the closer they get to bankruptcy.

A better idea than the one Perlmutter mentioned has been put forward by PPI contributor Robert Pozen in his new book, Too Big To Save. Pozen suggests delinking banking capital regulations from accounting mark-to-market rules by effectively recognizing all securities as being “held for sale” (an accounting distinction) for regulatory purposes. This would allow us to continue to keep the transparency in assets that mark-to-market allows, while avoiding the bottom line volatility that banks would like to avoid.

What to Do About Sarbanes-Oxley

The second idea is exempting firms from some Sarbanes-Oxley (SOX) reporting requirements. Passed in the wake of Enron, SOX was designed to hold companies and their executives accountable for their auditing, and eliminate some glaring conflicts of interest in financial auditing.

SOX does two good things. It makes a publicly held company have legitimate auditors, and ensures that those same auditors aren’t also advising the company on how to prepare the books for auditing (thereby basically handing over the answer key before a test). SOX also made sure that companies had proper controls that minimized the risk of errors in financial statements and of people either using company money inappropriately (as Enron did in off-balance-sheet shell companies) and of people embezzling money. Exempting firms from this would eventually lead to the same bad behavior happening again.

That said, SOX isn’t without flaws. Many in the auditing industry perceive it as very manpower intensive and, as a result, a significant burden to publicly listed companies, especially smaller ones (with income under $100 million). The SEC has responded by annually exempting small companies from some reporting requirements, but the exemption is not going to be extended past next year.

The solution to this problem is to streamline SOX to make it less burdensome to companies, not gutting it and letting new Enrons bubble up. Instead of providing an internal control report with each annual filing to the SEC — which can require up to three percent of a small company’s income — the SEC and Congress should encourage accounting oversight boards to spell out further guidelines and best practices to adopt. This streamlined SOX could even be extended to non-public financial institutions, as a key part of what allowed Bernie Madoff to steal people’s money for so long was having a small one-man upstate auditor keep tabs on his multi-billion dollar Ponzi scheme.