To: The Next President From: Eugene Ludwig, Founder and CEO, Promontory Financial Group, and former

Comptroller of the Currency Re: Smart Regulation for Financial Markets

Our governments approach to financial-services regulation over the last eight years has been a spectacular failure, bringing the United States and the world to the brink of financial ruin. The raw facts are stunning. During 2008, Americas investment-banking industry has all but disappeared through failure, forced merger, or conversion to bank holding companies. The countrys mortgage-banking industry has collapsed. Americas largest insurance company was nationalized to avert its failure. Our two largest government-sponsored enterprises, Fannie Mae and Freddie Mac, for all practical purposes failed and have been placed to a great extent under federal control. Three of the countrys 10 largest banking organizations were forced to merge, ending their independent existence. The remaining nine largest financial companies were partially nationalized. And the carnage is not over. There are many failures that caused this conflagration: the excess liquidity and structural deficits that allowed

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the U.S. government and the American consumer to live way beyond their means; excessive leverage allowing consumers, businesses and investors to prop up unsustainable lifestyles and profits; complex mathematical modeling and financial structures that were too little understood or tested; and low-quality lending practices that drove up financialinstitution profits at the expense of low- and moderate-income Americans. As you have pointed out, Mr. President, the theme underlying manyif not allof these failings has been an outmoded regulatory regime that has significantly abetted this outbreak of financial irresponsibility. Our country urgently needs a new regulatory paradigm to reestablish confidence in our financial system and to put in place a supervisory structure that helps to prevent a recurrence of the broad-scale institutional failures and market meltdowns of the kind we have just experienced. This memo proposes such a paradigm shift and outlines the contours of a new system of smar t financial regulation that is streamlined, comprehensive, conducive to economic efficiency and growth, and responsive to the needs of the American people.

Second, government intervention in markets to protect or assist individualsparticularly low- and moderate-income Americansmay be good-hearted, but is, in fact, counterproductive. Investors discipline the marketplace best. Any dishonest, anti-social behaviors by market participants need not be heavily policed, as the markets eventually will punish them. Third, serious, broadly based financial imbalances do occur, but these can be resolved by timely infusions of liquidity into the market. These periodic interventions by the central bank should be enough to restore equilibrium. This doctrine of regulatory minimalism has deep roots in American history. It harks back to the colonial era, when the Crown and the big English banks worked to constrain independent economic activity in their American possessions. Such concentration and centralization of power was rejected by our new republic, which at first allowed financial institutions to flourish with little or no governmental supervision. It was only after the chaos of the so-called wildcat banking era (and the political dislocations created by secession and the Civil War) that President Lincoln brought some level of order and regulation to the marketplace. He did this with the introduction of the National Banking Act and the National Currency Act in 1863, and the creation of a national-bank supervisor in the Office of the Comptroller of the Currency. Following several cycles of economic boom and bust, the great crash of 1929 and the resulting bank failures led to the New Deals financial controls and social safety nets. These regulatory innovations created a more stable balance of supervision and control on the one hand, and free-market

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A Brief history of Financial Regulation

The Bush administrations approach to financial regulation appears to have been based on three underlying assumptions: First, financial-market regulation and supervision often does more harm than good. It restrains market forces that provide innovative products and services that spur economic growth.

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dynamism on the other. They restored market confidence, essential to a healthy financial system, and underpinned more than a half-century of stability and growth. The New Deals regulatory framework, however, was buffeted in the postwar decades by several forces. On the world stage, technological change and globalization expanded the capital markets and made them more sophisticated. These forces favored larger financial enterprises and set the stage for fiercer competition from abroad. Closer to home, rampaging inflation (especially after the Vietnam War) led government to raise interest rates and eliminate interest-rate ceilings. This created new tensions and pressures in the domestic financial industry and dramatically recalibrated the competitive landscape. Innovations occurring outside the strictly regulated banksfor example, certain types of securities activitieseither drove banks into an unsound variance of these practices or simply led them to take bigger risks. Even as regulators grew in sophistication, they found themselves always lagging market developments. These changes in a dynamic marketplace, combined with weaknesses that had grown up in the regulatory systemas illustrated by the growing dysfunction of the Federal Home Loan Bank Boardlaid the foundation for the savings-and-loan crisis of the late 1980s and early 1990s. Congress and the White House responded effectively to these disruptions, establishing the Resolution Trust Corporation and giving rise to a decade of stability and growth in the 1990s. However, the Clinton administrations attempts to create a new and more comprehensive regulatory structure

were mostly stymied by lawmakers, with the exception of modest enhancements of the rules governing bank holding companies. Other Clinton-era efforts to respond to the dynamic marketplace and allow the financial sector to support a growing economy such as reform of the Glass-Steagall Act and removal of the prohibition on interstate bankingworked, even with a creaky regulatory structure, so long as the regulators in place were serious and collegial. This was largely true during the Clinton years. Even with the dedicated regulators of this era, however, the system had a hard time keeping up. Not only was regulatory reform slow in coming, but the ideology espoused and modestly practiced by Fed Chairman Alan Greenspan in the late 1980s and early 1990slighter supervision counterbalanced by ample liquidity in times of stress weakened the regulatory fabric. This market-knows-best mindset only became more entrenchedand more harmfulunder the Bush administration as regulations were weakened further. In recent years, only a relatively small part of the financial-services sector has been comprehensively regulated, as much financial activity has been conducted through loosely managed (and even more loosely regulated) vehicles or funds, often within what should have been regulated financial firms. For example, capital requirements and holding company rules encouraged capital arbitrage. This allowed banking organizations to reduce their capital obligations by operating financial activities through bank holding company affiliates. In some cases, these so-called special investment vehicles were created to hold instruments like leveraged loans and collateral-

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ized debt obligations. The theory was that the regulated unit would not be affected by a vehicles failure, a view that proved to be incorrect as bank after bank has moved the assets and the resulting losses back onto the balance sheet. The Bush-era regulatory environment also allowed the larger banks, broker-dealers, and insurance companies to create highly structured, unregulated instruments such as credit-default and interest-rate swaps that they sold to the public or traded among themselves. The construction of this house of cards was aided and abetted by rating agencies that were only nominally regulated by the Securities and Exchange Commission, and too often made rating errors. Ultimately, the ever-more-loosely regulated marketplace for financial services spiraled out of control as unregulated or underregulated mortgage brokers sold fraudulent productsso-called liar loans and pay option ARMs (particularly troublesome forms of adjustable-rate mortgages)to the public. New entities adver tising themselves as mor tgage banks then fed the loans through a technology-fueled securitization Vegematic, slicing and dicing them into tranches, which were optimistically rated and sold to investors all over the world. It is wor th noting that while the worst offenders of this system were underregulated financial companies, their loose practices resulted in many of these behaviors being employed by some regulated enterprises. To use another metaphor, excessive leverage and liquidity provided the kindling and

the gasoline, as the use of derivatives countenanced by all the regulatory agencies but particularly by the Fedcaught fire and eventually exploded.

The New Regulatory Paradigm

Such are the origins of the mess you have inherited. To restore public confidence in our financial system, you need a new paradigm that steers between the extremes of laissez-faire minimalism and nanny-state overkill. Indeed, such a regulatory model may prove particularly important at this juncture in American history, since we will have to wean the public from the emerging nationalized system of finance and back to a free-market system.This can only be done if public trust is re-established. You have promised to put teeth into our systems of financial-market regulation and oversight. As your economic team works to craft its approach, it should keep in mind two overarching themes. First, effective regulation can only be achieved if it incorporates effective supervision. Such supervision is based on real-time, hands-on examination of how banks and other financial institutions manage market risks. Articulating ambitious rules will be a pointless exercise if they are not implemented with vigor. Second, safety and soundness are cornerstone concepts of financial regulation.These words are not synonyms. Good regulation encompasses both the safe operation of financial-services firms (meaning prudent risk-taking) and the sound operation of such entities (meaning fair treatment of customers). Particularly in todays highly interconnected world, where reputation matters, it is hard to imagine that an institution can

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operate safely unless it operates soundly and treats its customers fairly. The past 150 years of American and international financial history have taught us that wisely designed regulatory systems can lessen the severity and frequency of panics and recessions. Here are seven principles for smart financial regulation that I hope you will find useful in your efforts to stabilize U.S. financial institutions and markets:
1. Comprehensive regulation for all, not just some. Our alphabet soup of multiple financial regulatory agencies permitted even regulated intermediaries to choose among regulators and select the most accommodating environment in which to operate. Though relatively few institutions avail themselves of this kind of regulatory arbitrage, its availability does cause some regulators to pull their punches. All financial institutions and markets should be comprehensively regulated. If some institutions are well regulated and others are not, then systems will tend to drift, if not rush, to the lowest common denominator. Furthermore, we need to ensure that the regulations we have on the books are reviewed periodically for effectiveness. Regulations often do not work as intended because they are staticor simply because they are well-intentioned but mistaken. Therefore, regulators need to be required to test on a periodic basis the effectiveness of their rules and supervisory practices. Indeed, it might be best to have those rules and practices audited from time to time by a third partyperhaps even by a nongovernmental body. 2. Counter-cyclical, not pro-cyclical, regulation. Effective regulation should tilt in the direction of counter-cyclicality. This means that when times are good, loss reserves

(the monies financial companies put away for a rainy day) and capital should rise. Conversely, when times are bad, reserves may fall, though capital should already be at sufficient levels so that it does not need to be increased. Similarly, accounting policy should not be pro-cyclical, making any highs appear higher and the lows lower than true economic conditions would ordinarily dictate. Accounting should be about measuring, not driving, economic reality. It is clear in the current cycle that mark-to-market accounting (in which assets are valued at their current market price) has not worked and needs to be modified. 3. Regulatory burdens minimized, bright lines preferred. Regulatory goals should be achieved through the least burdensome means possible. Heavy compliance burdens mean higher costs for consumers andto the extent that they misdirect financial executives from their main missioncan even undermine the safety and soundness principles that regulation is supposed to enshrine. In general, bright-line requirementssuch as capital ratios that derive from set numerical standards, not speculative models should be used as much as possible. In addition, regulations should align as closely as possible with market incentives and disciplines; in this regard, it is important that executive pay be tied as closely as possible to company performance. Public confidence in financial institutions and the marketplace suffers when executives are heavily compensated for pooreven disastrousperformance. Toward this end, regulators must have a clear picture of the financial underpinnings of the companies they oversee. For example, there should be a strong bias in favor of on-balance-sheet treatment for a financial institutions activi-

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ties. In addition, the financial-services marketplace must be transparent to regulators so the amounts of risk and their location are understood. 4. Strict limits on the use of leverage. Excessive leverage causes financial firms to be more volatile, and regulators must ensure adequate capital backstops for all financial services activities. Setting the right capital standards (the amount of capital a financial firm is required to put in a reserve to cover possible losses) is difficult. Capital requirements that are too high can cut off lending and depress economic activity. Certainly, different activities with different risk characteristics create differing capital needs. There are serious harmonization issues with respect to capital levels set by foreign governments. Furthermore, capital adequacy is one of the most impor tant but by no means the only important prudential rule. However, it is clear that the application of the Basel II capital-adequacy rules by the SECwhich allowed 40 to 1 leverage, and accordingly, extremely low capital requirements for investment bankswas seriously wrong. Capital requirements of 6 percent of total assets of high-quality capital (the so-called leverage ratio) as well as 10 percent of total assets risk based (somewhat lower quality capital) is closer to the mark. 5. More and better regulators. Smart regulation and oversight requires more regulators, and it requires that they be well trained and well paid. It is time to professionalize regulation and supervision; today, you can get a college degree in almost everything except regulation and supervision. Since such efforts will take years to bear fruit, it is important that your administration encourage universities to create strong academic programs at the undergraduate and

graduate levels in regulation, supervision, and risk monitoring. 6. Better coordination with other governments and agencies. In no economic sector has globalization made more of an impact than banking and finance. What happens in our housing market reverberates around the world. Yet, we continue to operate a balkanized regulatory system, both internationally and within the United States. Each European country has its own bank regulatory system, and the EU plays its own modest role; in the United States we have four federal bank regulators and 50 state regulators. Regulatory meetings in the United States and internationally make progress, but have too much of a Tower-of-Babel quality to them due to this multiplicity of voices. Even getting U.S. regulators to come out with subprime guidance took years, and then this achievement was watered down by the disagreements among the bureaucracies. To ensure efficient business operations and consumer well-being, and to protect the taxpayer from future bailouts, we must harmonize international standards and enforcement. 7. Regulation that serves consumers and communities. Smart regulators want the businesses they regulate to succeed, but their first concern should be for the consumers and communities that these businesses serve. Companies inspire confidence when they are financially safe and sound, decline to take undue advantage of their customers, and find ways to better their communities. In regulating the financial sector, we need to ensure that differently sized institutions are regulated appropriately so they are able to meet the needs of the communi-

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ties they serve. For example, it is important that regulation not become a means of eliminating smaller firms, such as community-based banks and financial institutions. For example, the capital rules of Basel II proved too complex for many community banks, and overly advantaged large, sophisticated banks. Even in their modified form, these rules create a playing field that is far from level.

derregulated. Second, the current alphabet soup of financial services, regulators, and enforcers is almost unintelligible to the public; encourages regulatory arbitrage; has led to less rigorous consumer standards than is desirable; and has trouble attracting a sufficient number of talented people to supervise larger and more complex financial companies, instruments, and markets. The global financial meltdown has unmasked these weaknesses and created momentum for serious change. Mr. President, I hope you will create a new paradigm of smart regulation designed to restore confidence in our financial system; check its tendencies toward excessive risk in pursuit of outsized gains; and restore its ability to generate wealth and value for the people of this nation.

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Conclusion
The old model of regulatory minimalism has failed our country in two principal ways. First, it is not sufficiently comprehensive; it allows a large portion of the financial services world to be either unregulated or un-

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