Heller lecture

Dr. H. Robert Heller
Financial Market Reform

Dr. Sam-Chung Hsieh Memorial Lecture, Stanford University
April 28, 2010

It is a great honor and privilege to give the Second Hsieh Memorial Lecture here at Stanford University. When you invited me several months ago to give this lecture on “Financial Market Reform”, none of us had any idea how timely this occasion would be.

This very week, debate on financial reform was blocked in the U.S. Senate – and so I am certainly happy that we can have a full and frank debate on this issue this afternoon here at Stanford! Our topic could not be timelier.

Let me begin by telling you what I plan to do: I plan to talk about the structure of our regulatory system; the proposed consumer protection agency; capital requirements, too-large-to-fail financial institutions; the resolution regime; proprietary trading and making markets safer for investors.

Given that we do not have unlimited time, I will not deal with hedge funds, pension funds, the insurance system, the credit rating agencies and compensation practices – all of which are addressed in the Congressional proposals now being considered.

We will also not have time to address reform of Fannie and Freddie, two very sick institutions at the center of the mortgage crisis. Both of them are most urgently in need of reform, but nothing is done about them in the current legislative proposals.

Before I get to the topics that I just enumerated, let me set forth two basic principles that should be incorporated in any financial market reform: first of all, we should recognize that the reform has to take place in an internationally consistent framework and second, let us not forget that neither regulators nor private market participants are infallible.

International versus National Regulation

With respect to the first principle, it is important to always keep in mind that financial markets are very highly integrated on a global basis. Any reform actions taken by any one country will have important international repercussions. If activities are prohibited or highly regulated by one country, these activities may simply move abroad and be carried out outside of the regulatory grasp of the country imposing these regulations. I need not remind this distinguished audience of the unexpected creation of the Euro-Dollar market in the Nineteen-sixties after the United States imposed capital controls.

Fortunately, we already have excellent international institutions where financial reform has been discussed at length. Foremost among them is the International Financial Stability Board (FSB) at the Bank for International Settlements in Basle, which has been established for this very purpose. It brings together the 26 most important countries in the international financial arena as well as all the international organizations active in the field.

The United States is well represented on the FSB by the Treasury, the Federal Reserve and the SEC and these deliberations are moving forward – albeit with somewhat glacial speed. To not take full account of these discussions and of this already existing body of institutional expertise would seem foolhardy indeed. Going it alone in the highly integrated financial sector would merely lead to new problems and open up potential new fissures in international financial markets.

Bankers and Regulators

Let me turn to the second observation, namely that neither regulators nor private market participants are infallible. Having worked on both sides of the fence, I can certainly attest to the validity of that proposition. During the recent financial crisis, both bankers and their regulators were found to be seriously deficient and few countries and institutions were able to survive the storm unscathed.

That leads me to believe that we should rely to the greatest extent possible on improving the structures and institutional arrangements and to rely as little as possible on the ad-hoc judgments of individuals or organizations. If we get the institutional structures right, we will not need much ad-hoc action by regulators and supervisors.

Simply calling for more and more supervision will not make the banks inherently safer. We should focus on a safer and more prudent design for our regulatory infrastructure. This is the topic that I would like to turn to next.

Reforming the Regulatory System

The United States is unique in that it has not only a dual banking system, where banks can avail themselves of national or state charters, but where banks are subject to an often overlapping regulatory system. Most other countries have a single bank supervisory and regulatory agency and a central bank. In some countries, these two functions are both exercised by the central bank, thereby consolidating both monetary and bank-regulatory policy in a single institution.

In the United States we have well over 50 organizations responsible for these functions. In addition to the Federal Reserve, which has both monetary policy as well as supervisory and regulatory functions, we have the Office of the Comptroller of the Currency and the FDIC at the national level as well as a state banking agency in every state. In addition, there is the Office of Thrift Supervision, the National Credit Union Administration, the SEC, the CFTC, as well as other agencies. Believe it or not, even the Agriculture Committee of the U.S. Senate plays a major role in the current financial reform debate.

It is certainly refreshing that the current reform legislation tries to bring some semblance of order into this convoluted system of regulatory overlap. The bill proposes that the OCC regulates the national banks and federal thrifts of all sizes as well as their holding companies with assets of less than $50 billion. In turn, the FDIC will regulate the state chartered banks and thrifts along with their holding companies – again up to a limit of $50 billion. Finally, the Federal Reserve will regulate bank and thrift holding companies with assets over $50 billion.

This consolidation will simplify matters considerably and create clarity, while preserving the decentralized dual banking system for the country. I believe there should also be a provision that the state chartered banks cannot branch outside the jurisdiction of that state so that all nationally active banks will have a federal charter and be supervised by the OCC.

The current reform proposal also establishes a new 9 member Financial Stability Oversight Council along with an Office of Financial Research in the Treasury Department.

It is difficult to see why one would charge the Federal Reserve with the responsibility for the oversight of all the large and systemically important institutions and then defang it by delegating the most important issues involving “risks to the financial stability of the United States” to the new Financial Stability Oversight Council. I assume this is mainly done to get the buy-in of the eight agencies represented on the Council – but then in typical bureaucratic fashion one independent member is added so that there will never be a tied vote!

In last year’s crisis, these financial stability functions were served very well by the Secretary of the Treasury and the Chairman of the Federal Reserve – without the presence of a new nine-member oversight board with its own research bureau. In my experience, these large interagency commissions tend to atrophy over time and become quiet backwaters without much power, while the real power is domiciled in the agencies. This is certainly the case for the FFIEC, which combines basically the same agencies as are represented on the proposed Council and thereby creates another set of overlapping Councils.

While the Bill streamlines to some extent the regulatory agencies, it also creates new ones – something that we can probably do without.

Consumer Protection Agency

The Dodd Bill also creates a new Consumer Financial Protection Bureau within the Federal Reserve. While the basic intent of consolidating the consumer protection functions housed in the various federal agencies is a good one, the advisability of housing the Bureau within the Federal Reserve is certainly questionable.

The main function of the Federal Reserve is the conduct of monetary policy. It is absolutely vital that the Fed is able to exercise this function independently and free from political interference. Everyone recognizes that consumer protection is a highly charged political activity, where various interest groups having a strong stake in what such an agency does and does not do. Thus, there will be constant political meddling and lobbying by interest groups in the consumer functions of the Fed, something that is fortunately a rare occurrence at the Fed right now. It is highly likely that this interference would also spill over into the monetary policy function. After all, raising or lowering interest rates has an immediate and significant influence on many credit terms and thus consumer welfare. Where will one draw the line?

In my view, it would be much better to establish the Consumer Bureau as an independent agency or house it in a different federal department. As far as I can tell, the main reason to have it placed in the Federal Reserve is that the Fed is also directed in the Dodd Bill to provide the entire financing for this new agency. This is certainly a nice way to avoid an explicit Federal budget allocation, but does not serve the long-run interests of the Federal Reserve’s independence.

Financial Reform Issues

Let me now turn to the core issues of financial reform: capital requirements, too-large-to-fail, a resolution authority, proprietary trading and making markets safer for investors.

Capital Requirements

Capital provides the cushion that allows financial institutions to operate in the face of risk and uncertainty. I find it useful to distinguish between two types of capital: One, the regulatory minimum requirements and two, the operating need for capital.

The regulatory minimum standards – generally 4 % for Tier 1 capital consisting of shareholder equity and retained profits and 8 % for Tier 2 capital, which also includes allowances for loan losses and subordinated debt, constitute mainly a protection for the FDIC and ultimately the tax payers. If the bank falls below the regulatory requirements, it runs the danger of being served with a restraining order or to be shut down. The required regulatory capital is not really available to the bank for operating purposes.

Bankers should more explicitly recognize the need for operating capital in addition to the regulatory minimum so that they can weather periods of stress. It is obvious that an institution that hopes to raise the necessary funds in times of stress will probably find it difficult – if not impossible - to do so. In times of stress, the markets may be closed or the institution will be forced to pay exorbitant interest rates.

Thus, it would be prudent to build up these additional voluntary capital reserves during good times and maybe forego lucrative investment or lending opportunities.

The IRS could be helpful here by allowing banks to set aside more funds on a pre-tax basis. As it stands, the IRS implicitly works against the establishment of additional reserves by taxing them, while the OCC encourages it. It would be nice for the Secretary of the Treasury to exercise some influence here as he supervises both the IRS and the OCC.

Capital for Large and Small Banks

The United States used to be a country with a highly fragmented financial system. Two sets of barriers erected after the Great Depression were responsible for this fragmented system: The McFadden Act prohibited interstate banking and thereby led to the containment on individual banks largely within state borders. In addition, the Glass-Steagall Act provided for a separation of commercial and investment banking.

While there are some observers that call for a return of the Glass-Steagall separation, I believe that this would be a serious mistake. As became apparent at the height of the recent financial crisis, free-standing investment banks were not able to weather the financial storm and had to convert quickly to bank holding companies and the regulatory support framework associated with it. On the other hand, well diversified financial institutions were able to cope much better. Re-erecting the Glass-Steagall barriers would not make the financial system more strong and resilient as it would reduce diversification.

The elimination of the interstate banking barriers resulted in the rapid establishment of truly national financial institutions, along with the expected economies of scale. For efficiency reasons we do need national financial institutions to support national corporations operating across state lines. This does not diminish the role of the many community banks that provide personalized services in many local communities across the country. But as I said already, these state-chartered institutions should be limited to operations within the state granting the charter.

Under the Basle II capital accord large and diversified financial are given favorable treatment as far as their capital requirements are concerned. The reasoning behind this move was that well diversified financial institutions presumably do not need as much capital as institutions that are not similarly diversified. Thus, small community banks are now required to have proportionally more capital than their larger competitors.

These lower capital requirements for large institutions added a regulatory advantage to the normal advantages of increasing returns to scale for large institutions and as a consequence they were able to outcompete and take over many smaller rivals.

The Financial Crisis of 2008 showed that large institutions are just as vulnerable as their smaller brethren during periods of widespread financial distress and all large banks were ultimately forced to accept federal financial assistance. If at the beginning of the financial crisis the largest US banks had held capital equal to that required for well-capitalized small banks -- or 10 percent of Tier 1 capital – they might not have needed any or much less financial assistance from the government. It is noteworthy that as a result of the stress-tests at present all the large US banks – Bank of America, JPMorgan Chase, Citibank and Wells Fargo meet this 10 percent standard. I would argue for institutionalizing these higher capital ratios on a permanent basis by revisiting the Basle Agreements with an eye towards equalizing the capital requirements for banks of all sizes all so as to establish a fair and level playing field.

Resolution Authority

This brings us conveniently to the topic of how to wind down very large institutions that are in trouble – the so-called “too big to fail” problem.

The arguments over a resolution authority are to some extent Washington insider turf battles. Both the FDIC and the Federal Reserve try to hold on to or even expand their regulatory turf against those who want to institute a new and more powerful and all-encompassing “Resolution Authority” for financial institutions.

The bankruptcy courts are also important players in this arena, but are largely quiet bystanders in the current debate. Throwing financial institutions into bankruptcy court is clearly a drastic, last resort solution and it impairs any continued functioning of the institution itself. For financial institutions, this is typically not a solution that preserves much value. Once the financial transaction flow stops, the value of the enterprise is rapidly diminished.

Under these dire circumstances, the FDIC attempts either to sell any financial institution it takes over to another organization or may even run the institution on a temporary basis until the assets can be sold off in an orderly fashion. Needless to say, this process becomes more and more difficult as the size of the institution increases and the potential bidders become fewer and fewer. These difficulties were aptly illustrated in the Bear Stearns failure, where a last minute rescue by JPMorgan was arranged, and in the reluctant marriage between Merrill Lynch and Bank of America. The failure to find a suitable acquirer for Lehman Brothers resulted in severe shocks to the entire financial system and the wisdom of letting the institution slip into bankruptcy will be debated for decades to come.

In any case, the difficulties associated with the Lehman failure also provide the impetus for current efforts to provide for an orderly shutdown of systemically important financial institutions.

The reform bill calls for large and complex financial institutions to provide their regulators “funeral plans” for an orderly shutdown of the institution, which will give the regulators a roadmap on how to proceed should the ultimate calamity strike. But it is in the very nature of catastrophic financial failures that many of the difficulties cannot be foreseen with any certainty. If one could plan for such a catastrophe, one could also develop plans that would avoid the catastrophe in the first place.

While there is some usefulness to be gained in thinking through the ultimate calamity, we should not deceive ourselves that the funeral plans left behind by the failing organization will always provide a secure roadmap for an orderly shutdown.

I am enough of a mariner to believe that we can learn something from the experience of ship-building. Modern ships are designed with a compartmentalized structure that hopefully helps to avoid the sinking of the entire ship if a collision or other calamity occurs.

Such a compartmentalization of activities within the holding company structure may well serve a useful purpose. The regulators spotting difficulties within one subsidiary may cease that subsidiary and either shut it down or sell it off before it threatens the safety of the entire corporation.

Having separate capital requirements for each subsidiary would also help to alleviate the competitive problem between large and small institutions that we discussed earlier.

Reform for Derivatives

Let me turn next to a topic that many, but not all, observers can agree upon: reform of the market for derivatives.

At present, most derivatives are traded in the over-the-counter market, with the very large global banks being counterparty to many of these transactions. The latest data from the BIS put the total value of all outstanding derivative contracts at over $600 Trillion – that is about 10 times the entire global GDP or $100,000 for every person on earth.

One of the reasons for this exceedingly large market size is that any request for a new transaction by an ultimate end-user immediately tends to result in a chain of further transactions as the first financial institution in the chain wants to reduce its position and does so by creating maybe several secondary transactions, which in turn cause tertiary transactions and so on – until a new equilibrium is reached. But all these exposures stay on the books of the individual institutions instead of being netted against each other.

During the recent financial crisis these complex and entangled derivative transactions on the books of some financial institutions – such as AIG, Lehman Brothers and Bear Stearns -- made other market participants reluctant to trade and thereby led to a total freezing-up of the entire market.

This complex web of continuing exposures could conceivably be replaced by a central clearing house for derivative transactions, where standardized contracts could be traded. As a result, many contracts could be offset or netted against each other and the effective size of the exposures would shrink drastically.

Instead of counting $600 trillion in global exposures, a centrally cleared and netted market may shrink to as little as $25 trillion. That is still a considerable amount of money, but compared to a world GDP of a bit more than $60 trillion, it will be less than half the size of world GDP instead of 10 times as much.

Moreover, the markets and the exposures of individual institutions would become more transparent and as a consequence the financial world would become safer.

Many observers agree that the establishment of such standardized contracts that are cleared through a central clearing house would constitute a vast improvement over the current arrangement – except, of course, the large banks which are the market makers in the current system and derive large profits from the inefficiencies and the opaqueness of the current market arrangements.

Proprietary Trading at Banks

This brings us to the topic of proprietary trading at banks and bank holding companies, namely the deliberate creation of open positions on the books of these institutions in the hope of a windfall profit. I restrict myself here to open positions at federally insured institutions, where ultimately the FDIC or even the taxpayer is on the hook to make up for any losses that might be incurred.

Open positions arise naturally as a consequence of the normal trading and market-making activities of banks. If, for instance, an industrial company calls up a U.S. bank and asks for $ 100 million in Euros, the bank will then have an open short position in Euros. Typically, it will then “lay-off” or “square” the open position by engaging in further trades with other institutions that have at that time excess balances of Euros.

If, however, the bank’s trader feels that the Euro may fall in value, the trader may be tempted to hold on to the short positions in Euros in the hope of being able to buy the Euros later at a lower dollar price and thus make an additional profit in addition to the trading margin.

For a bank that engages in thousands of transactions each day, it is easy to build up large proprietary open positions as a result of the normal trading activities – and thus it is very difficult, if not impossible, to distinguish a priori between regular trading positions and proprietary open positions.

Instead of prohibiting proprietary trading – which would be difficult to define – the regulators may simply impose very high capital requirements on any overnight open positions and thereby give the bank an incentive to reduce or eliminate its risk exposure. The regulators have that power now and the Basle framework is the appropriate forum to decide on the imposition of such standards on an internationally consistent basis.

Safer Markets: A Prodent Investors Exchange for Stocks

Next, let me turn to the stock market. While the stock market is not addressed in the financial reform legislation currently considered, it is an important segment of financial activity and many of the financial institutions covered by the reform legislation are active in this market.

Stocks went through a wild ride during the recent financial crisis and anything we can do to make this market safer and less volatile would certainly enhance financial stability. So, let us turn to this task next.

The vast majority of all stocks are held by investors who are either individuals saving for their retirement as well as pension and trust funds that have much the same purpose: namely to invest funds to achieve a prudent return for their investors. Many mutual funds also belong into this category.

Safety and a reasonable rate of return are the primary objectives of these investors.

There are very strict rules that individuals and money managers have to observe in these IRA, SEP, Keogh, 401k and other retirement funds. Namely, they are bound by the so-called “prudent investor” rules that do not permit short sales or purchases on margin. Most derivative instruments are also off-limit.

The same is true for many institutions, such as pension funds, insurance companies, trust companies and other investors that are often required by law or charter to adhere to a “prudent man” standard. That is, the majority of all participants in the stock market are long-term oriented investors that supply the capital necessary for a thriving economy.

But enter hedge fund managers, program traders and other short-term traders that devise fancy mathematical trading models and short-selling strategies and the previously safe road to retirement takes on a much more dangerous dimension.

It is difficult to argue that these market operators increase the overall return earned by the corporations in which they invest. These traders just hope to explore small market inefficiencies and be a bit faster in buying and selling securities than the long-term investors. They will change investment vehicles frequently, sometimes every few minutes or even seconds, and thereby hope to garner a significant slice of the available economic pie.

But does this help the long-term investor who is investing in the same stocks or bonds? I have a hard time in finding any evidence for that. Some argue that these traders increase liquidity in markets and that may well be true. But by engaging in large amounts of day-trading and quick in-and-out selling and buying, these short-term operators may also increase volatility and therefore uncertainty. By taking advantage of short-term profit opportunities, they attempt to take away part of the economic return that would otherwise accrue to the buy-and-hold long-term investor.

What is the solution?

I would like to propose a new set of trading rules that can be freely and voluntarily adopted by the corporations issuing these securities. If the New York Stock Exchange and the NASDAQ do not want to permit trading under these new rules, we may want to start an entirely new market where all securities are traded under these rules – we may call this market the “Prudent Investors Exchange” -- or PIE for short.

Under the Prudent Investor Rules there will be first of all no short sales; second, no purchases of securities on margin; and third, no derivative contracts could be linked to these securities. These are essentially the same rules under which all IRA and Keogh investors are trading in their accounts right now! Similarly, pension and trust funds investing under the “prudent man” rules have to invest under these restrictions. Thus, there will be plenty of natural investors who will be attracted to these securities and I would not expect a shortage of demand these types of products.

In addition, I would recommend a minimum holding period of one week for these securities. This would eliminate the day-traders and provide a level playing field and more security to the long-term investors who are not able to spend the entire day on a trading desk, but have other work to do.

So, let me repeat the simple rules of the Prudent Investors Exchange: No short sales, no margin purchases, no derivatives and a one week holding period. Each corporation would then be free to choose whether to list its securities to trade under these rules or stay with the current trading rules.

I presented this proposal recently to a group of about a dozen Chief Financial Officers of large Bay Area corporations – you would recognize the names of almost all of them instantly. At the end of the presentation, I asked for a show of hands of who might be interested in listing his company’s stock on such an exchange – and all hands went up. I must admit, however, that no financial institutions, stock brokers or banks were represented among the CFO’s around the table. Maybe the result would not have been so unanimous.

I would expect that corporations that want access to the funds of prudent individual investors, conservative mutual funds, pension funds and similar institutional investors that are bound by the “prudent man” rules to list on the PIE. Confidence would be boosted and investors would return to the markets so that corporations would again have access to the investment funds needed to restore growth and prosperity.

Clearly, these Prudent Investor Rules would not eliminate all fluctuations in the stock market. But events, such as the financial panic of late 2008, where speculative short selling amounted to 70 percent of the entire trading volume in some stocks -- and whose value plunged consequently by 50 percent or more in a just few days -- would be a thing of the past.


Let me summarize: I have argued that reform should proceed in an internationally consistent framework and should rely to the greatest extent possible on market principles and simple rules that will give the market participants appropriate incentives to behave in ways that do not endanger the safety and soundness of the entire system.

The regulatory system should be simplified and overlapping jurisdictions of the regulatory agencies should be eliminated. The proposed legislation accomplishes that goal to a large extent – at least compared to the current regulatory jungle.

The addition of a new Council charged with coordinating the various agencies in crisis situations would merely add another layer of bureaucracy that will only slow things down when speed may be of the essence. If the Fed is given the role regulatory role for all the systemically important institutions – as is proposed in the Senate legislation – then the Fed should also be the systemic supervisor.

Housing the new Consumer Protection Agency in the Federal Reserve is in my view mainly a budgetary gimmick that will not help to foster the long-term independence of the Federal Reserve System.

Capital requirements for large and small banks should be equalized to promote a level playing field.

A clearing house for derivative trading would do much to reduce the exceedingly large exposures in that market place and promote safety for all market participants. The increased transparency and standardization may also result in lower fees for commercial end-users, but reduce bank profits in this arena.

Proprietary trading by banks should be subject to sharply increased capital requirements to compensate for the riskiness of these often speculative exposures.

And finally, the stock market may be made safer by permitting corporations to voluntarily list their shares under simple trading rules that largely accommodate retirement investors, pension funds and others interested in long-term holdings of securities.

Thank you very much!