Will financial regulation plan stop a future $43 trillion mess?

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Last week the U.S. released an 85 page white paper on how it will change financial regulation. Why should we care? After all, the financial services industry is struggling and is not likely to add much more new damage to the stock market or the economy beyond the $30.1 trillion in wealth that it's destroyed and the $12.8 trillion of taxpayer money that has already been committed to bailing out its failures. Unfortunately, the plan adds a fresh coat of paint to a wobbly structure so when things get tough in the future we'll be in trouble.

If history is any guide, financial services will come back and we can't afford to let it batter the global economy again. That's why the financial regulation plan is scary. It glosses over an analysis of what caused the disaster and engineers a Washington bureaucracy that will create a bigger job for the ambitious members of the administration who are already bored with their current ones.

The plan's self-congratulatory tone -- full of insidery jargon like macroprudential, robust and systemic risk -- proceeds any evidence that the team has succeeded in solving the problems. The creation of a new bureaucracy to protect consumers from financial deception -- the Consumer Financial Protection Agency -- appears to have potential since it pushes for greater consumer education.

But the plan should create financial incentives for financial services companies to compete on the basis of fair dealing with consumers, rather than trying to raise the costs to financial institutions of cleaning up after tricking them.

This feature is the deepest flaw in the plan -- it focuses on cleaning up after disaster has happened rather than restructuring financial services so that such as disaster can be nipped in the bud before it gets to the point where taxpayer money needs to be put at risk to save the global financial system.

The key phrase in the white paper is a worthy goal that the plan does very little to achieve. It says, "In effect, our plan would compel these firms to internalize the costs they would impose on society in the event of failure." By these firms, the plan refers to what it calls Tier I Financial Holding Companies (FHCs), like Lehman Brothers, whose collapse brought on the disaster. The plan proposes that the Fed would oversee Tier I FHCs, creating a big new job for Larry Summers next year as Fed head.

But what the plan fails to do is to actually impose these costs on such firms. To do that, it would need to require their most highly paid people to keep their own pay in a capital account set aside to reserve against the cost of their failure. Unless the top people in such firms have their own pay at risk -- rather than extracting cash from others -- they will take big risks in the future for their personal benefit while shifting their losses onto taxpayers.

Moreover, the plan's superficiality will encourage shell games. How so? Once the U.S. defines Tier I FHCs, the big investment banks that might be subject to Fed regulation will change their structures so they can escape its control. If such restructuring made the firms less risky to society, that might be good. But most likely the changes would be in form, not substance.

And this is indicative of what the financial regulation plan misses almost completely -- people go to Wall Street to get rich. The only way to keep those people from getting rich through private profit and socialized losses is to change the way they get paid. The closest that the financial regulation plan gets to that is to provide shareholders with a non-binding say on pay. And that is typical of the plan's superficiality.

This plan is full of new words, but precious little change in the actual costs and benefits that financial leaders consider when they allocate capital. Without changing their decision calculus, the plan reinforces the very problems that got us into this mess.

Peter Cohan is president ofPeter S. Cohan & Associates. He alsoteaches management at Babson College. His eighth book isYou Can't Order Change: Lessons from Jim McNerney's Turnaround at Boeing.

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