In the news...

You may want to take a look at two interesting articles in today's WSJ as well as an editorial by Timothy Geithner and Lawrence Summers in today's Washington Post that describes the administration's plan to modernize financial regulation and supervision.

The first piece, "Risk Versus Executive Reward" highlights the challenge inherent in the administration's effort to curb excessive risk-taking by controlling the incentives for risk-taking built into compensation packages. The article explains that there is a split among the experts as to how -- or whether -- pay plans encourage these risks. One commentator argued that the pay practices blamed for corporate excess had little to do with the financial crisis and that "conventional-wisdom solutions" will either not work or may even exacerbate the problem. Other compensation experts have a different take, offering a variety on views on the types of compensation that are thought to rein in unnecessary risk-taking, including paying executives for longer-term, rather than shorter-term results and "clawing back" pay when prior profits disappear, tying executive pay to the performance of a company's bonds and preferred stock in addition to its common stock, basing bonuses on measures other than earnings per share, and avoiding big pensions, multiple performance measures, pay in excess of peers and pay for improving return on equity. Another commentator expressed the view that risk is the "hottest issue" facing compensation committees, in part because they may not know quite how to analyze the role of executive-pay practices in encouraging risk-taking as this point. The SEC is planning to require proxy disclosure regarding how compensation affects risk-taking, disclosure that companies that received TARP funding have already been required to make, with mixed results: while Citigroup offered an extensive three-part analysis, BofA provided a more terse statement.

The Post editorial, notes that the "current financial crisis had many causes. It had its roots in the global imbalance in saving and consumption, in the widespread use of poorly understood financial instruments, in shortsightedness and excessive leverage at financial institutions. But it was also the product of basic failures in financial supervision and regulation. Our framework for financial regulation is riddled with gaps, weaknesses and jurisdictional overlaps, and suffers from an outdated conception of financial risk. In recent years, the pace of innovation in the financial sector has outstripped the pace of regulatory modernization, leaving entire markets and market participants largely unregulated."

The plan focuses on five key problems in the current regulatory regime that the authors believe played a direct role in producing or magnifying the current crisis:

"First, existing regulation focuses on the safety and soundness of individual institutions but not the stability of the system as a whole. As a result, institutions were not required to maintain sufficient capital or liquidity to keep them safe in times of system-wide stress. In a world in which the troubles of a few large firms can put the entire system at risk, that approach is insufficient.

"The administration's proposal will address that problem by raising capital and liquidity requirements for all institutions, with more stringent requirements for the largest and most interconnected firms. In addition, all large, interconnected firms whose failure could threaten the stability of the system will be subject to consolidated supervision by the Federal Reserve, and we will establish a council of regulators with broader coordinating responsibility across the financial system.

"Second, the structure of the financial system has shifted, with dramatic growth in financial activity outside the traditional banking system, such as in the market for asset-backed securities. In theory, securitization should serve to reduce credit risk by spreading it more widely. But by breaking the direct link between borrowers and lenders, securitization led to an erosion of lending standards, resulting in a market failure that fed the housing boom and deepened the housing bust.

"The administration's plan will impose robust reporting requirements on the issuers of asset-backed securities; reduce investors' and regulators' reliance on credit-rating agencies; and, perhaps most significant, require the originator, sponsor or broker of a securitization to retain a financial interest in its performance.

"The plan also calls for harmonizing the regulation of futures and securities, and for more robust safeguards of payment and settlement systems and strong oversight of "over the counter" derivatives. All derivatives contracts will be subject to regulation, all derivatives dealers subject to supervision, and regulators will be empowered to enforce rules against manipulation and abuse.

"Third, our current regulatory regime does not offer adequate protections to consumers and investors. Weak consumer protections against subprime mortgage lending bear significant responsibility for the financial crisis. The crisis, in turn, revealed the inadequacy of consumer protections across a wide range of financial products -- from credit cards to annuities.

"Building on the recent measures taken to fight predatory lending and unfair practices in the credit card industry, the administration will offer a stronger framework for consumer and investor protection across the board.

"Fourth, the federal government does not have the tools it needs to contain and manage financial crises. Relying on the Federal Reserve's lending authority to avert the disorderly failure of nonbank financial firms, while essential in this crisis, is not an appropriate or effective solution in the long term.

"To address this problem, we will establish a resolution mechanism that allows for the orderly resolution of any financial holding company whose failure might threaten the stability of the financial system. This authority will be available only in extraordinary circumstances, but it will help ensure that the government is no longer forced to choose between bailouts and financial collapse.

"Fifth, and finally, we live in a globalized world, and the actions we take here at home -- no matter how smart and sound -- will have little effect if we fail to raise international standards along with our own. We will lead the effort to improve regulation and supervision around the world."

Another article in the WSJ, "Details Set for Remake of Financial Regulations" provides some meat on the bones of the plan for reorganization of financial-market supervision described in the editorial. The article reports that the "plan calls on the Fed to oversee financial institutions, products, or practices that could pose a systemic risk to the economy. It will create a 'council' of regulators to monitor this area as well. Government officials believe this arrangement will forestall companies from growing large and overleveraged without substantial federal supervision, as happened, for example, in the case of giant insurer American International Group Inc. The Fed will likely have the power to set capital and liquidity requirements for the U.S.'s largest financial companies and scour the books of a wide range of firms. It is unclear what enforcement powers the central bank will have; that likely will be a point of contention as lawmakers debate the issue. How the Fed interacts with this council also will be a subject of debate. Administration officials envision the council being able to recommend that a specific company, product or practice be subject to Fed supervision, with the central bank ultimately accountable for each area or company that poses the systemic risk. This could set up clashes between the Fed and the council, especially if one is more hawkish than the other." The plan will not call for a merger of the SEC and CFTC, but will instead push for more "harmonization" between these two agencies. The plan will also "call for several requirements to be adopted globally, such as tougher capital requirements for the largest financial institutions and the power to wind down large, globally interconnected banks. Administration officials also are calling for more transparency over complex derivatives that are traded by large, multinational companies." The measures are expected to come up for final votes by early fall.