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What's the Best Recipe for Financial Regulatory Reform?

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Long after the champagne bottles are uncorked and 2010 gets under way, the U.S. Senate will face the question of how to restructure our financial regulatory system. The House passed its version of legislation this month; it includes (among other measures) legislation that would permit the government to preemptively break up banks that pose a systemic risk to the system. (Rep. Paul Kanjorski personally spoke with me about this particular legislation.) That could potentially lead to the breakup of Bank of America (NYSE: BAC  ) , which acquired Merrill Lynch; or JPMorgan Chase (NYSE: JPM  ) , which was forced into the shotgun acquisition of Bear Stearns; or Wells Fargo (NYSE: WFC  ) , which acquired Wachovia.

The financial industry is in favor of certain proposed and passed measures and against others. (It should be noted that the two legislative houses will have to iron out the differences between their respective bills in conference committee before we see any final legislation.)

For insight from the industry on the overarching question of financial regulatory reform, we asked the following four well-known experts for their opinion:

  • Bob Pozen, chairman of MFS Investment Management
  • Mohamed El-Erian, CEO and co-CIO of Pacific Investment Management Co. (the world's largest bond investor)
  • Robert Shiller, Yale finance and economics professor, the co-creator of the S&P/Case Shiller Home Price Index, and author of numerous books
  • Charles Geisst, the man who called the 2008 financial meltdown four years prior(!), a professor of finance at Manhattan College, and author of 15 books

What follows are excerpts from past interviews with these experts, none of which have previously been printed. Without further ado:

Bob Pozen: If you ask what is the most significant regulatory requirement, I think it’s capital and leverage. What we’ve seen is, if you allow relatively low capital and high leverage, you put institutions in a position where they look like they’re really doing great if things are going well. But if things go bad, they really have to scramble and everyone runs for the exit door at the same time.

Probably one of the single most destructive decisions regulators made was in 2004, when the SEC allowed the five investment banks [for example, Morgan Stanley (NYSE: MS  ) and Goldman Sachs (NYSE: GS  ) ] to double their leverage ratio from 15-to-1 to 30-to-1. At 30-to-1, if you get a small number of losses you’ve got to sell a lot of assets to get back. And if everyone does it at the same time, you really have a panic.

It seems to me a big mistake was allowing banks to lever up. Maybe this is a question more for the SEC, but should there be limits placed on the amount of leverage firms should take on?

Mohamed El-Erian: Optimal regulatory reform would reduce systemic risk without excessively burdening innovation and entrepreneurship. This is a delicate balance to strike at the best of times, and especially in the aftermath of a major financial crisis.

It would be hard, though not impossible, to reinstate Glass-Steagall. The concern is that a reinstatement would end up being too blunt a response, given the market realities of today and tomorrow. I suspect that we could go a long way to meeting the objectives of better regulation through more effective capital requirements, including a countercyclical element, clearer resolution mechanisms, and sensible leverage guidelines.

Robert Shiller: I think [financial regulatory reform] is a step forward. The thing that impresses me most is the financial consumer protection agency. It’s actually something I endorsed in my book Subprime Solutions, because a lot of bad things happened because of products that were not really designed with the benefit of consumers in mind. So having a CFPA will make for a better world. There’s concern about it stifling innovation, but I think if it’s managed well ... it will promote innovation, because it will be real innovation that benefits people. So that is an important thing.

The other thing is the financial services oversight council. I think that is an interesting proposal. It’s not as dramatic as it could be, because it doesn’t give the council regulatory authority, but it does create someone whose responsibility is to worry about systemic risk and work with various regulatory agencies. I think that’s a step forward. [However,] it doesn’t necessarily solve all of our problems, because if we had had such an agency five years ago, it probably wouldn’t have seen this coming anyway. But I think it’s a good step.

Charles Geisst: ... I think the Fed should not be a securities regulator. They should stick to banking. Though they do need better inner forms of security because, for example, Greenspan gave his implicit blessing to credit default swaps. That’s part of the background, which made [the banks] explode the way they did.

... I think this is mostly a structural argument. I think most people want to argue it in terms of function. I just don’t think that’s a good idea. I think it has to be structured properly, and then the function still has to be monitored. If you don’t restructure these institutions and try to manage their function, it’s just going to be a nightmare.

Jennifer Schonberger: There’s been a lot of talk about preemptively stomping out bubbles before they pop. In fact, Fed Chairman Ben Bernanke, who has traditionally been against this idea, is rumored to be considering such an approach. Do you think this is a good idea, or do we risk sustained growth but at a lower rate?

El-Erian: I do favor a more active policy approach to “leaning against the wind” should there be growing indications of asset bubbles. This would temper the inevitable overshoots that financial markets are subject to, while also reducing the risk of bad contamination for the real economy.

In considering all these issues, it is important to remember that one should not make the best the enemy of the good. Optimal regulation and, more generally, an optimal financial policy stance are hard to achieve. Moreover, requirements will evolve as innovations materialize and institutional structures develop. As such, the regulatory mind-set, and in particular the openness to midcourse adjustments, plays a critical role in ensuring outcomes that are desirable in terms of both systemic risk reduction and growth promotion.

For more insight from these experts:

Fool contributor Jennifer Schonberger owns shares of Bank of America, but does not own shares of any of the other companies mentioned in this article. The Motley Fool has a disclosure policy.

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