This morning, the Obama Administration outlined its proposals for tightening financial regulations in an Op-Ed article by Tim Geithner and Larry Summers in The Washington Post. The key sections of it are below, and I have interspersed my reaction and commentary:

“This current financial crisis had many causes. It had its roots in the global imbalance in saving and consumption, in the widespread use of poorly understood financial instruments, in shortsightedness and excessive leverage at financial institutions. But it was also the product of basic failures in financial supervision and regulation.”

Put another way, the U.S. consumed too much and saved too little, and it stopped innovating to the extent it had in the past, with the exception of financial innovations. The vast majority of those innovations had no real social utility, they just served to make transactions more opaque and complicated. Investors bought into them because they wanted to be “sophisticated.”

Keep in mind that simplicity is a virtue when it comes to investments. If you cannot clearly understand what an investment is about, and are not able to explain it to a 12 year old, you should probably stay away from it.

“Our framework for financial regulation is riddled with gaps, weaknesses and jurisdictional overlaps, and suffers from an outdated conception of financial risk. In recent years, the pace of innovation in the financial sector has outstripped the pace of regulatory modernization, leaving entire markets and market participants largely unregulated.”

One of the arguments that you will hear is that putting on more regulations will slow the pace of financial innovation. This, however, would be a good thing. They are right that we need to start regulating the shadow banking system.

“That is why, this week — at the president’s direction, and after months of consultation with Congress, regulators, business and consumer groups, academics and experts — the administration will put forward a plan to modernize financial regulation and supervision. The goal is to create a more stable regulatory regime that is flexible and effective; [one] that is able to secure the benefits of financial innovation while guarding the system against its own excess.”

This worries me — they think there are significant benefits to financial innovation. Would someone please tell me what exactly the benefit of Credit Default Swaps has been? How about CDO’s? Sure, they create lots of fee income on Wall Street, and as a result generate some very big bonuses. But how have they helped your average firm in the real economy? How have they helped consumers?

“In developing its proposals, the administration has focused on five key problems in our existing regulatory regime — problems that, we believe, played a direct role in producing or magnifying the current crisis.

“First, existing regulation focuses on the safety and soundness of individual institutions but not the stability of the system as a whole. As a result, institutions were not required to maintain sufficient capital or liquidity to keep them safe in times of system-wide stress. In a world in which the troubles of a few large firms can put the entire system at risk, that approach is insufficient.”

Yes, the approach was insufficient, especially when the regulators were asleep at the switch and firms were allowed to choose their regulator.

“The administration’s proposal will address that problem by raising capital and liquidity requirements for all institutions, with more stringent requirements for the largest and most interconnected firms. In addition, all large, interconnected firms whose failure could threaten the stability of the system will be subject to consolidated supervision by the Federal Reserve, and we will establish a council of regulators with broader coordinating responsibility across the financial system.”

The key point here is the higher capital and liquidity requirements. This means less leverage and thus lower returns on equity over time. It appears they are saying that big institutions like J.P Morgan (JPM) and Bank of America (BAC) will be most affected by this, thus lowering their relative ROE’s as well as the absolute ROE’s.

“Second, the structure of the financial system has shifted, with dramatic growth in financial activity outside the traditional banking system, such as in the market for asset-backed securities. In theory, securitization should serve to reduce credit risk by spreading it more widely. But by breaking the direct link between borrowers and lenders, securitization led to an erosion of lending standards, resulting in a market failure that fed the housing boom and deepened the housing bust.

“The administration’s plan will impose robust reporting requirements on the issuers of asset-backed securities; reduce investors’ and regulators’ reliance on credit-rating agencies; and, perhaps most significantly, require the originator, sponsor or broker of a securitization to retain a financial interest in its performance.”

This is an important step — the retention of a financial interest in securitizations. A big key will be how big a stake. I would suggest it be tied to the fee income the deal generates, perhaps saying that the “skin in the game” for the originator of the loan has to be 2x that of the income generated, and for the sponsor (the one who buys up all the originations and slices and dices them) that they hold 3x the amount of the fee income generated by the deal.

Over an extended period of time, say five years, the institutions would be able reduce their skin in the game to perhaps half of the original amount, but never lower than the original fee income associated with the deal.

“The plan also calls for harmonizing the regulation of futures and securities, and for more robust safeguards of payment and settlement systems and strong oversight of ‘over-the-counter’ derivatives. All derivatives contracts will be subject to regulation, all derivatives dealers subject to supervision, and regulators will be empowered to enforce rules against manipulation and abuse.”

I would prefer to see “over-the-counter” activities greatly curtailed and all derivatives trading done on exchanges with central clearing houses.

“Third, our current regulatory regime does not offer adequate protections to consumers and investors. Weak consumer protections against subprime mortgage lending bear significant responsibility for the financial crisis. The crisis, in turn, revealed the inadequacy of consumer protections across a wide range of financial products — from credit cards to annuities.

“Building on the recent measures taken to fight predatory lending and unfair practices in the credit card industry, the administration will offer a stronger framework for consumer and investor protection across the board.”

Very much overdue. Perhaps there should be an equivalent of the FDA for financial instruments. Before a new type of instrument can be offered to the public, say for example a new type of mortgage, it would have to pass muster with a Financial Products Safety Commission, just like a new drug has to pass the FDA.

“Fourth, the federal government does not have the tools it needs to contain and manage financial crises. Relying on the Federal Reserve’s lending authority to avert the disorderly failure of nonbank financial firms, while essential in this crisis, is not an appropriate or effective solution in the long term.

“To address this problem, we will establish a resolution mechanism that allows for the orderly resolution of any financial holding company whose failure might threaten the stability of the financial system. This authority will be available only in extraordinary circumstances, but it will help ensure that the government is no longer forced to choose between bailouts and financial collapse.”

The devil will be in the details here and elsewhere, but the AIG (AIG) experience shows that this is very much needed.

“Fifth, and finally, we live in a globalized world, and the actions we take here at home — no matter how smart and sound — will have little effect if we fail to raise international standards along with our own. We will lead the effort to improve regulation and supervision around the world.

“The discussion here presents only a brief preview of the administration’s forthcoming proposals. Some people will say that this is not the time to debate the future of financial regulation, that this debate should wait until the crisis is fully behind us.

“Such critics misunderstand the nature of the challenges we face. Like all financial crises, the current crisis is a crisis of confidence and trust. Reassuring the American people that our financial system will be better controlled is critical to our economic recovery.”

I wholeheartedly agree that the time to work on a new regulatory structure is now. The people who want to wait are the people who have a vested interest in the system staying the way it is. After the crisis has passed, nobody will be paying attention, and the bank lobby will have even more power than it does today. Any new regulation that is postponed would be done in back rooms and would work to the disadvantage of consumers and small investors.

In following the debate on these issues, things will get complex and your eyes will start to glaze over. For a good short-hand way to tell if an idea is a good one, look to see if it is being supported by the big bank lobbyists. If it is, the presumption should be that it is a bad idea for everyone else.

“By restoring the public’s trust in our financial system, the administration’s reforms will allow the financial system to play its most important function: transforming the earnings and savings of workers into the loans that help families buy homes and cars, help parents send kids to college, and help entrepreneurs build their businesses. Now is the time to act.”

Actually the time to act was a few years ago, but unfortunately we don’t have a working time machine.

Read the full analyst report on “JPM”
Read the full analyst report on “BAC”
Read the full analyst report on “AIG”
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