A Wall Street Lawyer's Take on Financial Reform
Brown, a partner at Milbank Tweed in Washington, D.C., says financial reform deserves "a pretty good grade" from a taxpayer's point of view. Taxpayers should "take some comfort from a very elaborate [legislative] exercise." But "they should be skeptical [that] every problem is solved by legislation." Nevertheless, financial reform "imposes costs on the industry in the form of capital and liquidity requirements and restores credibility to the public at large."
From Wall Street's perspective, Brown gives financial reform a grade of B -- noting that "efforts by the industry were significantly successful." While he was worried about the Volcker Rule, which would have required Wall Street to divest their private-equity and hedge funds, he was pleased with the "turnaround" at the end of the process that let Wall Street retain interests in those funds up to 3% of Wall Street's so-called tangible common equity, a form of capital.
Brown is also comfortable with the way the new financial regulations treat derivatives. That's because there are so many exceptions to the requirement that derivatives be registered with a clearing organization and be traded on exchanges. If a so-called end user is involved in a derivatives transaction -- for example, a company that has borrowed money and wants to limit its exposure to rising interest rates -- that derivatives transaction can be made outside the confines of an exchange.
Taking on the Causes of the Crisis
In Brown's opinion, the new financial regulations will do a good job of dealing with the causes of the recent financial crisis. He feels that the Consumer Financial Protection Agency will help protect consumers from dangerous mortgages, but that as a new agency it's likely to create controversy. He also thinks that creating a derivatives clearinghouse will require transactions to be registered with the Commodities Futures Trading Commission, subjecting the trades to capital requirements and posting of collateral.
I asked Brown to comment on how well the financial reform bill addresses what I think are the six biggest causes of the financial crisis. He thinks it does a good job on most of them. Here's why:
- Capital requirements were too lax on broker-dealers -- letting them borrow $50 for each $1 of capital. Brown thinks that limits on such borrowing will be worked out in the regulatory process, although he also is of the opinion that the financial world is so chastened by the crisis that it will police itself.
- Compensation programs rewarded bankers for taking on big deals regardless of risk because their bonuses hinged on closing deals. If they failed, they knew they could shift losses onto taxpayers. Brown said financial regulation did not limit executive compensation, but that's fine because the public doesn't understand that most of Wall Street pay comes from bonuses. And he thinks that most firms are balancing long- and short-term considerations in pay.
- Securitization let issuers of bundled mortgages and credit card receivables profit by sprinkling bad loans in with good one and making everything look all right -- until the bad loans nearly wiped out the global financial markets. Brown defends securitization as "brilliant" and argues that since loan originators would now have to keep some of their loans on their books, the problem is solved.
- Ratings agencies competed to give AAA ratings on bundles of toxic waste so they could get paid high fees by issuers. Brown admits that the financial reform package preserves this system of letting issuers pay ratings agencies, but he thinks that more in-depth disclosure of how ratings agencies develop ratings will solve the problem.
- Too-big-to-fail. Prior to financial crisis, a Wall Street-friendly bias in Washington enabled financial institutions to merge and acquire their way to sizes so large that one's failure could bring down the financial system. Now those institutions are even bigger. Brown says there's a debate among those who think that financial regulation goes a long way to helping this problem, and those who feel it doesn't. He wasn't willing to take a strong position in this debate.
- Letting managers write their own report cards helped enable frauds like Bernie Madoff, who sent fake account statements to his clients to keep them investing with him. But Brown didn't see any reason to end the practice of letting managers produce their own financial statements, and noted that nobody in Washington was even considering a change to this practice. Brown pointed out that everyone involved with public financial disclosures is extremely focused on following the rules.