Sandy Weill's Regulatory Suggestions

Monday's edition of the Wall Street Journal featured an editorial by Sandy Weill, ex-CEO of Citigroup, and Judah Kraushaar. In it, Weill articulated six steps which he believes will "revitalize" the US financial system.

I was a little surprised to find that I actually agreed with several of Weill's ideas, given that he is responsible for assembling the failed mess that is today's Citigroup.

Weill starts out on the wrong foot by, as you'd expect, defending the concept of "too big to fail" as moot and irrelevant. By choosing to see the recent financial mess as caused by Lehman's failure, which isn't, strictly speaking, true, he feels he can simply declare bank size of no practical importance.

I would beg to differ. What got the ball rolling on this crisis was the mid-2007 failure of two Bear Stearns mortgage-related mutual funds. By year end, Citigroup, Merrill Lynch and others were hastily writing off a combined hundreds of billions of dollars of marked-to-market mortgage-backed holdings.

Lehman marked the end of the valuation-based failures of private sector, publicly-held firms, not the beginning.

However, despite Weill's very biased view on this point, which might be expected to color his entire analysis, several of his other points actually make sense.

The first one, unfortunately, does not. Weill wants the Fed to be the financial super-cop. There's so much wrong with this idea that I couldn't deal with it, and Weill's other remarks, in one post. Suffice to say, you don't give more power to the guy who just misused the considerable power he already had. Also, I'd note that Weill was, for nearly his entire career, a securities industry operator. I'm not entirely sure he really understands Fed regulation.

His second point is worthwhile. He, like me, believes that "complex instruments," by which I assume he includes derivatives, should have regular market pricing and be traded through exchanges. The much-feared daisy chain effect of AIG's financial products unit failing would have been eliminated, had its derivatives positions been held via an exchange which required posted collateral. Exchanges remove counterparty failure risk, and would have removed most of the concern over an AIG or Lehman failure in the first place.

Another point Weill makes, which echoes my own prior posts, is to force underwriters of structured financial instruments to retain a healthy portion of the issues, and regularly sell portions to affirm their pricing.

His desire for regulators to somehow oversee the ratings agencies isn't really sensible at all. Just from stories I've heard from senior rating agency employees, it's clear to me that they face undue pressure from their clients, as well as intellectual and technical intimidation. It's unlikely that a bunch of mid-level civil servants at regulatory agencies will ever be capable of going toe to toe with Wall Street financial engineers and produce a useful result. Bank regulators are used to simply counting things and comparing existing reserves to required ratios, reviewing loan documents, and generally checking accounting and paperwork. They aren't securities valuation experts.

Perhaps the best of Weill's suggestions is that regulators stop messing with bank loan loss reserves. According to Weill, the regulators have been pressuring financial institutions to lower reserves in the healthy portion of the lending cycle, then take larger reserves as losses mount. He's correct to note that classical banking does the reverse- fund the loss provisions in good times, both to match losses to when the loans were made, and to smooth out the effects of loss recognition.

Finally, again, reinforcing published work of mine going back to the mid-1990s, he endorses making more senior executive compensation dependent upon and only vested after longer time periods. While he advocates the wrong metric, ROE, his basic instinct is correct. Long term vesting, lagged average total-return based compensation will put a stop to executives reaping quick cash bonuses while avoiding longer term consequences of risky strategies.

Overall, I was pleasantly surprised with Weill's ideas. For a guy whose best years in the financial service industry were spent hoovering up ailing wire houses and rationalizing their back offices, he actually seems to understand more about risky front office behavior than you'd guess from his failure in creating the monstrosity called Citigroup.