Professor James Van Horne, of Stanford University, recently wrote an article identifying sixteen United States’ credit crises during the last two hundred years. Even if he were off by one or two, Enough! I remember too many in my lifetime. As a way forward, I suggest the next set of regulation rid itself of three premises:
- Sophisticated investors need less protection, and
- People, unchecked by peers, will honor large dollar contracts
- Business models should be independent of financial structure
Alan Greenspan notoriously reiterated that our economic systems relies on trust. Unfortunately, the reality suggest that too much trust facilitates financial crisis.
Regulatory Dimensions That Matter
Policy makers can succeed by concentrating on two dimensions of financial transitions. The first accounts for whose money is used. The second, focuses on what will be done with the money—the underlying promise. These two dimensions focus attention on the economic system’s core principle, expected economic return. If people can comprehend a positive expected return, economic activity will occur.
From the policy maker’s perspective there is a continuum of possibilities for measuring whose money is used—from one-hundred percent the decision-makers’ money to zero percent. However, unlike the first dimension, what’s done with the money is really a binomial outcome—conduct an economic activity or give the money to someone who conducts economic activity. In the later case, when decision maker “A” gives money to decision maker “B,” one can question “A’s” value. I do not. Efficiently matching investor and investment risk profiles, is not an easy task. And in so performing, decision maker “A” provides value to the economic system. Thus spending money, deploying capital in profit seeking ventures and efficiently matching investor risk profiles to investment risk profiles are all valuable economic activities.
What Should We Regulate
Regulation needs an anchor by which to require behaviors. Hence the investment transaction, is a natural event on which regulatory efforts focus. But who are economic actors? Well, actor number one delays consumption by saving—Saver. Actor two takes other’s savings in exchange for a promise to return money after using it for an economic activity—Spender or Investor. And lastly, are people who make money in an advisory capacity, that is they make money by matching risk profiles for those delaying consumption, and those promising to return money—Adviser or Banker. Each actor has important economic responsibilities or activities, which regulators must insure occur. Significantly, regulation cannot insure the quality of these activities when undertaken, nor is that their role. However, financial crises exist because one or more of these activities are bypassed or lax regulatory environment facilitate improper expectations.
Saver Behaviors
Savers must understand the inherent risk of what the decision maker’s promises to do with their money. This includes Spenders or Investors, or Advisers or Bankers. Additionally, Savers must understand two important features of the investment process:
- the regular reports of investment value made during interim periods, and
- how to demand their money’s return.
Regulation is needed to make sure information is available.
Spender or Investors Behaviors
The first behavior is really quite simple, tell the saver how their money will be used. The disclosure is needed to ensure the matching of risk profiles. Second, tell the saver why they should trust that their money will be returned. American society has failed during the last two hundred years to adequately make these disclosures, and appropriately now desperately needs new regulation here. Today’s regulation is particularly poor at informing investors at the time of the transaction who else has a claim on the spender’s or investor’s cash flow, and after the transaction when new investors arrive that have been granted a higher priority for getting money back. Thus Savers and their agents have no ability to constrain too much spending or borrowing and little clue about when to demand their money’s return.
The Spender or Investor should put in place safeguarding practices. These practices are future behaviors that protect the money they are promising to return. Additionally, there should be a reporting requirement that commits the spender or investor to informing others on the progress of safeguarding practices, and the interim value of the investment. Regulatory requirements must distinguish among economic activity conducted when the money was received, but the core requirements exist, nonetheless. And lastly, there should be no ambiguity for procedures for the saver to demand their money back.
Adviser or Banker Behaviors
Most financial service employees are in this category, where their core function is to match risk profiles between Savers and Spenders or Investors. Market stability is only helped by advisers clearly declaring who pays for their services and who holds their fiduciary interest. While various transaction cost might be needed to value specific behaviors (such as, checking account fees and loan application fees), one side of the transaction always pays more than the other, allowing the adviser to earn an income for their services and pass along the remaining money between the two parties. The fiduciary duty is not always clear, but government regulation should make it so to bring transparency to the business models and raise the level of financial stability. Playing both sides, is obviously profitable, however, the inherent conflicts will merely lead to the next financial crisis.
In creating a fiduciary duty, the industry regulators can now focus on behaviors that ensures that transparently advisers perform their duties. Conflict of interest disclosures, comparative performance and safety and security of principal all become much more easily managed in a world with clear fiduciary duties.
System Required Regulation
Some regulation needs are driven by the functioning economic system. These regulatory schemes help match risk profiles and allow advisers to function with common rules. Because the rules are common, regulation must be clear about how others use the structure that has been established.
Government Insured Value
To help investment advisers conveniently manage small balance accounts, the government guaranteed account values. The guarantees simplify the responsibilities and activities of the Savers and Spenders or Investors However, simplified actions does not eliminate risk.
The FDIC should be the regulator in charge of those who offer guaranteed accounts. At this point, too much regulatory focus is upon the adviser who holds money in custodianship until demanded. However, the FDIC should increase the level of disclosure required of people who use this money for economic activity. Government reporting of safeguarding practices and interim reporting by users of this money are far too lenient.
Additionally, advisers should not be allowed to mimic the features of government insured accounts without contributing to the insurance costs and constraining features. Thus, money-market accounts, should be banned from existence. By operating similarly to government insured accounts, and not providing the insurance, Savers are bilked into a phony sense of security that risk financial stability whenever the phony security is exposed.
Conversely, the federal reserve should set targets for the portion of the money supply that should exist in government insured accounts, and alter monetary policy to encourage the flow of funds. Much like policy is established to influence bank reserves, Savers utilizing government insured accounts should be managed from a money supply perspective, and not a competition perspective between individual adviser institutions.
Government Processed Default Procedures
The bankruptcy code specifies the rules and how any investment arrangement is settled if the spender or investor cannot return the money as agreed. As the government specifies the resolution, then the government should specify behavior before default to encourage the proper balance of defaults in the society. Spenders and Investors who use Saver’s money and agree to government sponsored protections if default occurs, should have to operate within a government specified framework that protects the financial market process.
One primary area of regulation needed in society is with consumer spending. From one perspective the government encourages spending to drive the country’s economy, but on the other, society does not want too many defaults. Regulation that focuses on Spender and Investors’ disclosure requirements for their safeguarding practices (namely, total spending or total debt caps) and disclosure of future debt transactions are highly beneficial.
The banks (people who make advisory money) erred when pursing more stringent bankruptcy arrangements to deter consumer overloading of debt. A better method would have been a new agency (although the SEC would be the natural agency to extend) whose sole focus would be regulating the reporting requirements of individuals and companies who are subject to government sponsored bankruptcy should they default.
The primary reporting requirements would be
- Safeguarding practices
- Repayment schedules
- Total debt loads (for example, household level net worth statements, analogous to company annual reports)
- Household debt ratings, or credit scores.
With spenders and investors making full disclosure, advisers who make risk profile matching decisions would have the information they need, not only at the time of transaction, but importantly, at interim reporting periods. Such disclosure would also encourage a market for securities prior to maturity. Collateralized debt obligations failed because the marketplace applied average default assumptions to pools of debt. With common reporting and a rating system in place, obtaining debt would become a pricing decision based on the quality of risk matching and supply and demand of investors.
Alternative Default Procedures
Where two parties enter into agreements that remove bankruptcy as a mechanism to address counter-party default, then different rules must apply. The cornerstone of this proposed government regulation is mitigating the risk that a counter party does not pay. Hence, the regulatory reporting requirements would focus on proper disclosure practices and fraud prevention. Regulatory coordination would be needed to prevent a spender or investor form pledging assets for inappropriate purposes.
Here a regulated clearinghouse would appropriately address counter-party risk. The model agency would be the Commodity Futures Trading Commission, which operates today’s regulated derivatives market. Today’s clearinghouse framework would need modification to absorb most notions of insurance backed by investors own equity. Insurance supported through, debt financing, would likely need bankruptcy support and thus be under the prior business model.
This leaves the idea in place, that business models using debt and equity (that is different financial structures), would have different regulatory requirements, assuming those who provide debt wish to rely on bankruptcy if needed. Thus, business models funded by different financial structures, should meet different regulatory environments. A welcome sense of the financial risk undertaken I suspect.
Tax Treatment of Interest & Dividends
A key commonality to the history of financial crises, is the use of other people’s money in leveraged transactions. It’s no secret that leverage is a route to large investment returns on equity. However, risk ignorant use of leverage must stop. Requiring the disclosures describe above will help, but a crucial component in government policy is the tax distinction between interest and dividends. Debt and equity are different by their claims to asset in bankruptcy, and in the certainty of their amount. But tax differences are artificial with real consequences in the motivations they provide. Hence, removing artificial policy differences, helps reduce the profit incentive of using leverage. I propose financial policy grounded in:
- Interest deductible by payers, then taxed as income by receivers
- Dividends not deductible by payers, and not taxed when return of capital, but taxed as income when there is a return on capital.
Crucial to altering tax policy is the need for an easy way to distinguish a dividend payment as return of capital from a return on capital. I suggest the government learn from its treatment of inventory accounting. With inventory, the government lacks insight to the order and exact nature of which purchase transactions supplied the goods sold within a specific period. To resolve the tracking ambiguity, entities select one scheme (for example, FIFO, LIFO, or average cost) to account for inventory, and are not encouraged to change schemes. Similarly investors could select a scheme and be restricted or discouraged from changing the scheme. With a dividend payment scheme presumed, government could account for individual behavior through tax returns and audit as necessary.
Summary
All financial market actors should be regulated. The scheme of regulation depends crucially on two questions:
- Does the government insure the value of the investment?
- If credit default occurs, is government managed bankruptcy the expected resolution?
