| Let’s
Make a Deal, Regulatory Style
Heads, I Win; Tails, You Lose
MAY 2008 - The
recent bailout of Bear Stearns was the ultimate irony. For years,
investment banks have been fighting against government regulation
and intervention in the free market, crying that the competitiveness
of the U.S. capital markets would suffer from greater regulation.
Then suddenly, when they need help, where do they turn? To their
new favorite relative—Uncle Sam!  The
decision by federal regulators to underwrite a $30 billion credit
line to JPMorgan Chase for its acquisition of Bear Stearns has
been controversial, to say the least. Parts of the acquisition
either stretched the rules or ignored them completely. At the
time the agreement was reached, JPMorgan purchased 39.5% of Bear
Stearns’ stock to ensure that it would have the votes necessary
for shareholder approval of the deal. This action was allowed
in spite of a New York Stock Exchange rule (Listed Company Manual,
section 312.03) that requires companies to obtain shareholder
approval before issuing more than 20% of the company’s current
outstanding stock in any transaction (with limited exceptions).
So, do the ends justify the means?
Subsequently,
the Federal Reserve also opened up its emergency loan program—the
“discount window”—to other large investment
banks, a program that was previously restricted to commercial
banks. Many have questioned the prudence of the Fed’s recent
generosity to investment firms and called for them to be subject
to increased regulation, similar to that of commercial banks,
in exchange for access to the discount window.
Regaining
Confidence by Playing a Con Game
To placate
those who may have noticed the latest rule-bending, Treasury Secretary
Henry M. Paulsen, Jr., outlined a new blueprint on March 31 to
regain investor confidence in the U.S. financial markets. His
proposal contained short-, intermediate-, and long-term recommendations
for changes to the financial regulatory structure.
The short-term
plan would create a new mortgage commission charged with protecting
homeowners. At the intermediate stage, several federal agencies
would be consolidated: the Office of Thrift Supervision would
be eliminated and the SEC would be merged with the Commodities
Futures Trading Commission. The long-term plan would create two
new regulatory agencies: a “prudential financial regulator”
to focus on the well-being of financial institutions that provide
specific government guarantees, and another that would monitor
businesses to protect consumers. The
Fed would be given broader powers, becoming a “market stability
regulator” charged with the responsibility of addressing
liquidity and funding problems.
Although
Paulsen’s blueprint offers no additional oversight or regulation
for investment banks, the media are calling his proposals the
“biggest market overhaul since the Great Depression.”
To me, it seems like we are simply trading one set of agencies
for another. Is this the government’s version of the old
shell game?
Paulsen made
clear last year that the Treasury and other regulators believe
that “market discipline is the most effective tool to limit
systemic risk.” But how do we ensure market discipline in
the world of investment banking, which, of late, seems to be run
more like a casino where the government now covers the bad bets
of players like Bear Stearns?
Learning
from Our Mistakes
One suggestion
would be to conduct a thorough review of what happened in the
Bear Stearns case and analyze how it might have been prevented.
Learning can be achieved in many ways. Lessons learned from our
mistakes (the “hard” way) are painful, but they can
also be very effective.
Capital reserve
requirements are an important tool that regulators could use to
force a more conservative approach within the financial market
system. While increasing the capital levels required of investment
banks would admittedly redirect available resources away from
other uses, it would be prudent and equitable to bring the reserve
requirements for investment firms in line with those of commercial
banks.
Implementing
full disclosure (e.g., by putting all structured investment vehicles
on the balance sheet) and consolidating regulatory authority to
better enforce existing rules could help to minimize the risk
of another Bear Stearns’ occurrence. The current piecemeal
structure allows aggressive dealmakers to exploit cracks in the
system by creating an endless array of new financial instruments
that fall outside of regulatory oversight. The participants in
our financial system must cope with many challenges; however,
figuring out which agency should have oversight for any specific
financial instrument should not be one of them.
Paulsen indicated
in his speech that his blueprint should not be acted upon “this
month or even this year.” Next year, of course, we’ll
have a new president and all bets are off. But if I were asked
to call the coin toss …
As always,
I welcome your comments.
Mary-Jo
Kranacher, MBA, CPA, CFE
Editor-in-Chief
mkranacher@nysscpa.org
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