One Year Later: No progress on a new financial architecture

A year ago, I suggested that finance plays too large a role in our enew-financial-architectureconomy. It's supposed to support the investment decisions of CEOs, but it has turned into the tail that wags the economic dog -- accounting for 8 percent of GDP, double its level in the 1960s Not only does finance come up with new products and then sell the world on buying them to boost banker pay, but it expects -- and gets -- society to use taxpayer money to keep the bonus money rolling in when those products implode.

That's why I thought in September 2008 that it would be helpful to re-architect finance. So far, there has been no progress along the lines I proposed and I believe that the moment of urgency on which to base such reform has passed. Therefore, we are almost assured of future financial panics. So for those who will be around the next time a crash happens, here are six principles -- five I mentioned last year and one new one -- upon which we could base a new financial architecture:

End securitization. As I wrote then, if financial engineers can find a way to bundle loans into securities that are guaranteed not to lose money for investors, then securitization should continue. The collapse of the market for MBSs and CDOs demonstrates that achieving this could be nearly impossible.

If there is a way to reconstitute the benefits of securitization -- namely, lower interest rates for borrowers -- without the costs we're now incurring, then it might make sense to continue the practice. Otherwise, end it for good. Regrettably, securitization lives -- Wall Street now wants to create a $500 billion securitization market to bet on your death.

Low leverage. As I wrote then, we should closely monitor all actors in the financial system -- including banks, hedge funds, insurance companies, businesses and households -- to set clear targets for maximum leverage and to ensure that none of these actors is able to exceed those targets. More importantly, we need to create a culture of savings and living within one's means to extinguish the urge to borrow and spend more than one can repay.

For the moment, leverage appears to be lower -- although Goldman Sachs Group (GS) is using it to make record profits through trading. But there's no solid mechanism in place to keep excessive leverage from reemerging throughout the system during the next economic recover.

Complete transparency. As I wrote, trust in the financial system depends on timely, accurate and complete information. Such information should extend across all kinds of financial transactions -- providing investors with the ability to assess the financial strength and future prospects of the companies in which they invest; giving companies knowledge of the soundness of their partners, suppliers and customers; and providing consumers a true picture of the honesty -- or lack thereof -- of their lenders and brokers.

In the year since I made that suggestion, the Madoff scandal has revealed that we are still suffering the effects of letting managers write their own report cards. No progress has been made on freeing us from that systemic flaw.

Morally defensible incentives. As I posted, bankers and other participants in the financial system get paid to bring in big volumes of business. Their bonuses are calculated as a percentage of the size of their deals. If investors later lose their investment from those deals, the bankers get to keep their money. To fix this problem I would require them to keep their bonuses in an escrow account.

If after, say, five years, that investment was still valuable, the banker would receive the money out of escrow. Otherwise, the escrow would pay the losses that the investor incurred from the bad deal. This kind of structure could reduce the moral hazard in the current incentive system by encouraging bankers to book deals likely to make money for investors.

A year later, there's a comp cop in place, but no progress on this change in banker pay.

Global firewalls. Last year, I suggested that designers of our new financial system needed to establish ways to keep the problems of one institution from bringing down others -- whether in the U.S. or in other parts of the world. For instance, AIG's collapse could have damaged many of its inter-connected CDS counter-parties. However, that problem would not have arisen if there had been an independent exchange for trading CDSs.

There has been talk of such global firewalls and there may actually be some success in building them.

Finally, there's a sixth principle that I did not mention last year:

Break up companies deemed too big to fail. I believe that there is a limit to how big financial institutions should get. When they exceed that size, the government should require them to break themselves up into smaller pieces. The reason is that we should not be rewarding managers for building big companies that can't earn a profit that exceeds their cost of capital. And we should not require taxpayers to pay for the cost of such failure.

While the FDIC has argued on behalf of this principle, it appears to be losing the bureaucratic battle.

Unfortunately, none of the proposals to reform Wall Street are making much headway. Why not? Wall Street -- with its $5 billion in cash to Washington over the last decade -- is resisting the reform efforts. And key economic officials -- such as Tim Geithner and Larry Summers -- have benefited handsomely from Wall Street, and perhaps hope to get huge financial rewards for their defense of Wall Street after they leave government. Perhaps President Obama's Monday speech on financial regulation can help -- but that remains to be seen.

Although these reasons might explain why we missed this opportunity to fix the financial architecture -- I'm really not sure why. Unfortunately, the rest of society will pay the price for that failure.

Peter Cohan is a management consultant, Babson professor and author of eight books including, You Can't Order Change. Follow him on Twitter. He has no financial interest in the securities mentioned.

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