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Edward D. Hess Headshot

What's Lost in the Debate Over Financial Regulation Reform? Real Reform.

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The Obama administration has announced its intention to continue pressing for financial regulation reform; lawmakers on the other side of the aisle have vowed to oppose new legislation. Clearly we have a fight on our hands. The question too few people are asking, however, is whether a "victory" by either side would actually get at the deeper, systemic problems at the heart of our financial system.

In a new book, Smart Growth (Columbia Business School Publishing, 2010), I subject a number of core presumptions of both Wall Street and major corporations about business growth to the scrutiny of hard research--presumptions that were major contributors to the 2008 financial meltdown.

You know the accepted wisdom: that businesses must "grow or die," that all growth is good, bigger is always better, and that public companies must show consistent, quarterly, linear growth. The problem with those presumptions is that there is no empirical, scientific evidence for them whatsoever.

These unjustified beliefs toward business growth lead companies and their executives to take a damaging, short-term approach to the business. And that, in turn, skews financial reporting in ways which, though legal, hide rather that reveal the true state of a company's health.

Consider the effect on the financial system when most stock transactions are made merely by short-term traders and "renters" of stock. More than 70 percent of all public stock is owned by institutions whose average holding period is 12 months or less.

This short-term mentality has two bad outcomes. First, companies defer real investments in the growth and innovation needed to pull the US and global economy out of the downturn.

Second, companies spend time, money and intellectual capital creating or manufacturing wasteful and distorted non-authentic earnings that do not represent real growth or innovation. What exactly are those "non-authentic" earnings? They are the non-operational numbers created by accountants and investment bankers: valuation estimates, accounting adjustments, investment transactions, channel stuffing, and other financial engineering tactics.

In effect, these numbers are illusions. They do not represent the fundamentals of a business that are important for long-term viability and competitiveness.

Authentic earnings, on the other hand, are an indicator of the strength of a company's customer value proposition. They represent the sale of more value-add goods and services on customary commercial terms to unrelated customers in arms-length transactions. Authentic earnings are superior indicators of growth because they represent information about the underlying vitality, differentiation and market acceptance of a company.

The ominous implication here is that even the modest, somewhat tentative recovery being experienced today is merely an earnings bubble supporting illusory stock market values.

A number of insightful analyses are now in circulation, highlighting ways that America can avoid these same kinds of mistakes in the future. Matthew Bishop's and Michael Green's The Road from Ruin, for example, calls for the adaptation of market-efficient economic theory, the evolution of global monetary policy, and the change of capitalism to a broader purpose than just creating shareholder value. They suggest a rethinking of shareholder democracy, executive compensation, and the need for the U.S. to become more humble about its form of capitalism.

Simon Johnson's and James Kwak's 13 Bankers looks at the current concentration of economic and political power that has been paradoxically enhanced by the recent financial crisis, and calls for systemic reforms to lessen that concentration of power in order to mitigate the risk of another big financial crash.

To these analyses I add the following recommendations that can refocus corporate America on actions that can spark real growth. To change the rules of the financial game in a way that can actually correct the structural flaws in the current system, several concrete steps can be taken.

  • First, public companies should be required by regulators, listing exchanges and their boards of directors to disclose with complete transparency their non-authentic earnings.
  • Second, the short-term renting of stock should be discouraged by increasing the holding period for long-term capital gains to three years and imposing fees on nontaxable institutional short-term stock renters, as well.
  • Third, executive compensation should be more properly aligned with the long-term creation of real growth.
  • Finally, public companies should be made to disclose their short-term and long-term growth portfolios, so long-term investors can better evaluate and allocate their capital to smart, rather than apparent, growth.

I don't hear these points being made often enough or loudly enough on either side of the current debate over financial regulation reform. One wonders the extent to which true reform is even on their agenda. To use the old phrase, the debate is generating lots of heat, but not enough light.