– Robert Bench, a former Deputy Comptroller of the Currency in the Reagan administration, is a senior fellow at the Boston University School of Law Morin Center for Banking and Financial Law. The views expressed are his own. –

Financial Institutions inherently are fragile, simply because they are intermediaries exposed to both exogenous and endogenous forces.

Externally, they are vulnerable to wars, weather, or worn-out economic conditions. Internally, they always are susceptible to excessive risk takings as well as inadequate controls over operations.

Therefore, financial institutions historically have projected strength two ways. First and most obvious have been their buildings, designed of granite, with strong doors and deep vaults, to show the institution was a “fortress” against troubled times. Less obvious, but more importantly, they maintained “fortress balance sheets” comprised of high levels of capital, high levels of liquidity, and massive “hidden” and “inner” reserves.

Accounting, tax, and regulatory policies accommodated salting away profits in good times, so they would be available to draw down during bad times, which were sure to occur. The policy bias in both the private and public sectors was to preserve stability within the “public utility” that is the financial system.

But the recent history of financial policy has been to abandon these historical building blocks in the financial fort. Tax policies no longer accommodate the build-up of loan loss reserves. The Securities and Exchange Commission set policy when they complained to a major institution that it had tucked away too much money in reserves. The SEC also permitted investment banks to operate with 50 percent less capital while the banking regulators allowed the banks themselves to decide how much capital and reserves they needed.

The mantra of “maximizing shareholder value” led to religious attempts to precisely measure risks and profits without any recognition of the history as to how financial institutions are absolutely unlike commercial firms.

So we as citizens have been exposed to the procyclicality dangers of finance because the countercyclical protections we used to have were abolished. A procyclical financial system amplifies booms and busts. History shows we want a countercyclical financial system that dampens booms and cushions us against trouble.

The collapse of the procyclical financial system has required staggering taxpayer assistance to restore stability. European taxpayers have had to nationalize and/or intervene to save their financial system. According to the Federal Deposit Insurance Corporation, the American taxpayer has made available some $13.9 trillion in support facilities to U.S. financial institutions while also doubling the national debt as taxpayers were forced to take over some $5 trillion in liabilities of Freddie Mac and Fannie Mae.

The G20 initiatives to require more capital, in terms of liquidity and reserves, at financial institutions represent a return to countercyclical policies for the financial system. Indeed, the initiatives in the short term comprise a quid-pro-quo for the massive taxpayer bailout that has occurred. We have been through the rescue, are into repair, and now beginning the reform and retribution stages of recovery.

The recent public policy of privatizing profits and socializing losses is unacceptable to taxpayers. The financial and economic destabilization of the past year has been difficult for millions of households. So for the long term the G20 proposals intend to lessen the event of future instability. But when it does occur, shareholders will absorb the losses, not the taxpayers. In essence, we are transitioning from “too big to fail” to “too safe to fail.”

For sure, these new government requirements will lead to altered and perhaps less profitable business models. Financial institutions will become less dynamic and more cautious. But the financial system and the economy likely will be less volatile, more stable. Financial institutions will return to serving commerce, households, and governments — rather than serving themselves

Indeed, the fundamental question inherent with the G20 initiatives is what do societies want the financial system to do and how do financial institutions get on with the job? The invisible hand of the marketplace failed. It is being replaced with the very visible guiding hand of government. The Reagan/Thatcher period of deregulation is over. The financial system is a public good mandating robust public regulation and oversight. Expect that solid, “fit and proper” financiers will welcome the G20 initiatives.

It is in the best interest of the financial institutions themselves to fortify their financial conditions so as to restore trust in the marketplace. Normality will not return to the financial system until trust is restored in the competence of government oversight as well as in the integrity of governance exercised by directors and management of financial institutions.

– Robert R. Bench, a former Deputy Comptroller of the Currency in the Reagan administration, is a senior fellow at the Boston University School of Law’s Morin Center for Banking and Financial Law. The views expressed are his own. –

“Le laissey faire, c’est fini” – French President Nicolas Sarkozy

There indeed is a French flavor to the administration’s proposals for reforming the structure of regulation and supervision of financial institutions operating across the United States. In many ways the proposals resemble the “Commission Bancaire,” the French regime for financial oversight.

Perhaps the proposals reflect commitments the U.S. has been making at the meetings of the G20 countries, consisting of countries which finance much of U.S. government operations and American consumer credit.

If we want those countries to continue to be our banking lifeline, we need to engage in reforms to satisfy their expectations for financial discipline and integrity. We cannot restore confidence and trust in our financial institutions and markets until investors feel again that U.S. financial transactions are on the “up and up.”

The same goes for domestic investors and savers. Financial institutions made promises to U.S. pension funds, municipalities, and trusts. Those promises were broken, as losses of 20, 30, and 40 percent have been incurred. U.S. financial institutions sold “dreams” to American financial consumers: first house, vacation house, student loans, secure retirements, etc. For some, those dreams are totally broken. For many, the dreams have turned into nightmares.

U.S. customers of U.S. financial institutions rage at those institutions’ lack of performance and executives’ performance bonuses. U.S. financial leaders sit on the beach while American taxpayers are stuck on a treacherous fiscal sandbar.

In essence, this financial crisis has reminded us all that the financial system is a public utility and the U.S. financial institutions are chartered by the government because of their social utility to the commonwealth.

In recent years, unfortunately, financial institutions became less involved in financial service and consumed by financiering for the sake of volume — because volume drove individual compensation up and down the executive ladder. Splendid financiering is the work of rascals and humbugs, wrote Hugh McCullough, the first Comptroller of Currency in 1863. President Obama’s new proposals are dealing with 21st century rascals and humbugs.

The proposals are for getting back under the umbrella of government charters the financial transactions that escaped the regulatory umbrella in recent years. They are intended to show global investors and U.S. taxpayers that Washington intends to return U.S. finance to a safe-and-sound enterprise first and foremost, but should something go wrong in the future the losers will be private capital and not taxpayer capital.

The proposals call for a return to a “trust but verify” regime in which significantly more federal examinations will be carried out across all elements of U.S. finance. This will include a stronger advocacy for consumers of financial products.

More specifically, the president’s reforms call for a dramatic extension of federal regulation and supervision of financial markets and financial institutions, while also calling for a status quo and/or expansion of financial supervision in state governments. All significant financial holding companies will fall under regulation and supervision of the Federal Reserve. So will all significant clearing and settlement systems for financial products.

Financial institutions will have to have more capital reserves and liquidity, cushioning the taxpayer from risks. Those cushions will be managed in a counter cyclical way, i.e., the institutions put away more earnings in good times so it is available when things go wrong. And they’ll have to put it away in protection before they can pay it out in compensation. This process will involve the accountants coming up with revised policies for marking-to-market and for loss reserves, further dampening any chance for irrational exuberance in the future.

Significantly, the president’s proposals provide for special bankruptcy proceedings to deal with sick, large financial institutions. The FDIC has those proceedings for sick banks and this year is deploying those proceedings just about weekly. But big problems arise when the bank is owned by a holding company and that holding company is large, complex, and likely multinational. For an enormous amount of reasons, normal bankruptcy rules cannot be used because that involves freezing activity at the holding company, which in turn would freeze the entire financial system because of interconnectedness. So, new, customized wind-up processes need to be devised for large, systemically important financial institutions, not just banks.

The president requests new processes because without them the government remains stuck in the rut of using taxpayer monies to keep the sick company afloat. And trust and confidence in finance will not be restored until sick financial companies are resolved.

If this reads as if we have entered “old Europe” somewhat, perhaps we have. The financial system and institutions in it have failed the “test of the marketplace.” The “invisible hand” of the marketplace has needed the guiding wallet of the American taxpayer. Financial managers have privatized their profits but socialized their losses. Reforms are necessary to restore the balance between the government and its government-chartered institutions.

Personally, I would have liked the president’s proposals to have spoken more about restoring integrity in private-sector governance. That also must come in order to regain confidence. Maybe we need a simple proposal to change “CEO” to that European “Governor” to remind executives on whose behalf they really work for every day.