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Simple Rules for a Complex Financial World

Thursday, July 30, 2009

Complexity has been the bane of our financial system for decades and cannot be the solution going forward.

The Treasury Department’s plan for reform of the financial supervisory system makes the classic Washington mistake of equating more intricate oversight with greater discipline. In fact, complexity has been the bane of our financial system for decades and cannot be the solution going forward.

We have created an intricate, multifaceted terrain of opportunities for sharp dealing through our financial regulations, tax codes, and accounting rules. There are multiple federal regulators and state alternatives. Different jurisdictions offer varied enticements in terms of favorable legal structure and tax treatment. And the tax code ranges across regions and over time.

Financial firms have burrowed into every nook and cranny. This has required the effort of legal specialists, accounting experts, and financial engineers. As a result, the balance sheets of large firms have been splintered into a collection of special purpose vehicles, and securities have been issued with no other purpose than extracting as much value as possible from the Basel II Supervisory Accord. This complexity introduces three fundamental problems in monitoring behavior.

It is probably not an accident that financial firms tend not to be targets for hostile takeovers—their balance sheets are impenetrable from the outside.

First, supervisors are at a decided disadvantage in understanding risk taking and compliance for a firm that might involve dozens of jurisdictions, hundreds of legal entities, and thousands of contractual relationships. Firms know this and tailor individual instruments to a small slice of its clientele to take advantage of tax and accounting rules. And the same risks might be booked in different ways across affiliates, let alone across different institutions, with evident consequences for capital requirements. Indeed, the reliance of self-regulation inherent in the Basel II Supervisory Accord can be seen as an official admission of defeat: a large complex financial institution cannot be understood from outside.

But if an institution is so difficult to understand from the outside, how can we expect market discipline to be effective? The second cost of complexity is that the outside discipline of credit counterparties and equity owners is blunted. Creditors are more likely to look to the firm’s reputation or a stamp from a rating agency rather than the underlying collateral provided by the financial contract. Equity owners are more likely to defer to senior management, opening the way to compensation abuses and twisting incentives to emphasize short-term gains. In this regard, it is probably not an accident that financial firms tend not to be targets for hostile takeovers—their balance sheets are impenetrable from the outside.

Third, the problems in understanding the workings of a complicated firm are not limited to those on the outside. A complicated firm is also difficult to manage. Employers will find it harder to monitor employees, especially when staff on the ground have highly specialized expertise in finance, law, and accounting. Simply put, employees who are difficult to monitor cannot be expected to promote the long-term interests of their workplace. What follows are abuses in matching loans and investments to the appropriate customer and, in some cases, outright fraud.

If an institution is so difficult to understand from the outside, how can we expect market discipline to be effective?

Note the irony. A firm’s effort to take advantage of government-induced distortions by becoming more complicated and by making its instruments more complex lessens the owner’s ability to monitor management and management’s ability to monitor workers. Market discipline breaks down.

Sometimes the answer to a complicated problem is simple, as Alexander found with the Gordian knot. Cut through the existing tangle of financial regulation. Consolidate federal financial regulators and assume state responsibilities. Simplify accounting rules and the tax code. Make the components of financial firms modular so that the whole can be split up into basic parts at a time of stress. With simple rules that define lines more sharply, our federal regulators will find enforcement much easier. If firms are more transparent, official supervision will be reinforced by the new-found discipline exercised by shareholders and creditors. And with fewer places for self-interest to hide, employees will be more accountable in their efforts to preserve the longer-term value of their firms.

The consolidation of multiple agencies and the shift of power away from states to a single federal entity seem daunting. Even harder might be the necessary reduction in the variety of corporate charters and the pruning of the tax code and accounting rules. Indeed, this is an invitation to jurisdictional warfare, as each regulator jockeys for viability. But a more established set of rules for the resolution of large firms, simplification of regulations generally, and consolidation of supervision specifically should be the aspiration of this Congress.

It is also patently fairer. Being bigger or more complicated or having better lobbyists will not covey an advantage in a world of clear lines, strict enforcement, and no exceptions. We have lived in a world of fine print and sharp lawyers and look where that got us. We are ready for change.

Vincent R. Reinhart is a resident scholar at the American Enterprise Institute.

FURTHER READING: Reinhart wrote “The High Cost of Getting the Story Wrong” on how the narrative first written about the Great Depression was mistaken in many important respects, as is the initial narrative on today’s crisis. His other pieces for The American include “When They Were Young,” a look back to the last time that Larry Summers, Director of the National Economic Council, and Timothy Geithner, Secretary of the Treasury “saved the world.”

 

Image by Darren Wamboldt/Bergman Group.

 

 

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