The Financial Sector Reform: Three Interesting Developments

September 3, 2010

The new U.S. legislation for the financial sector is now one month old. It rewrites the rules in every branch of finance including consumer protection, derivative-product trading and bank risk management. At the same time, regulators around the world are also redesigning other national financial regulations. Three developments have caught my attention:

  1. Higher capital requirements, especially for larger financial firms: According to U.S. Treasury Secretary Timothy Geithner, “All financial crises are, at their core, caused by excess leverage.” Therefore, a key element of the reform is an increase in capital requirements and relatively less debt for all financial institutions. Because the bankruptcy of a large bank poses a threat to the stability of the overall financial system, larger U.S. banks will be required to hold relatively more capital than smaller ones to cushion large losses.
  2. More clout for shareholders: New proxy rules will make it far less costly for large shareholders to nominate their own candidates to boards of directors. This will likely improve the governance of financial firms. The financial crisis was partly caused by bank managers and brokers making decisions—with the support of complacent boards—that served their own interests rather than those of their shareholders. Better representation of the shareholders on boards will help prevent such behavior in the future.
  3. Creditors bail-ins: A committee made up of finance ministers and financial regulators from G20 countries is working on a system to require that any loss suffered by a distressed bank be borne by its bondholders, before the taxpayer has to step in and rescue it. If a bank shows signs of distress, its regulator would be authorized to convert its subordinated bonds into common equity, thereby relieving the bank of part of its debt burden. Banks can be expected to manage their affairs more prudently when there is little hope for a government bailout and when more responsibility is borne by bondholders.

In conclusion, despite all the gloom in the capital markets these days, the financial reform seems to be on the right path. The cornerstone of a stronger financial infrastructure is definitely higher capital requirements. But the world of finance is complex and there is no silver bullet for instability. Capital requirements can be, to a certain extent, circumvented with accounting tricks, financial engineering and all sorts of legal structures. Therefore, the problems plaguing the financial system must be attacked on several fronts including shareholder rights and financial-distress procedures. The challenge going forward will be enforcing these regulations in ways that effectively foster stability but don't paralyze the economy with bureaucracy.

Raymond Kerzérho

Chairman of the Investment Committee
and Director of Research
PWL Capital Inc.