A Better Way to Improve Financial Regulation

06/01/2010 05:12 am ET | Updated May 25, 2011

While the current hubbub regarding re-regulation of financial institutions has drawn more than its share of criticism, it does represent progress as a meaningful effort to avoid financial meltdowns by preventing financial institutions from doing things that cause catastrophic consequences to themselves and require costly bailouts. This is a significant evolution from last year's pointless controversy over compensation which has little to do with ensuring the soundness of firms.

However, while the Obama Administration is to be commended for moving the debate to something that genuinely impacts society, the outcome of the decisions undertaken by financial institution managements, its approach remains misdirected. This article describes a more efficient and effective method for avoiding severely problematic outcomes for firms that imperil the broader economy.

In an effort to avoid "too big to fail" situations requiring bailouts, the Administration and Mr. Volcker propose to limit the size of financial firms and prohibit them from engaging in securities trading for their own accounts. This effort is likely to be ineffective or counterproductive for several reasons:

• Much of our current situation results from poor decisions made by small and medium-sized institutions which had nothing to do with proprietary trading - namely drastic erosion of mortgage and other credit underwriting standards.

• Proprietary trading can result in risk reduction and financial benefits enhancing bank capital and lending capacity.

• It is difficult - some would say impossible - to differentiate between proprietary trading and trading on behalf of customers.

• There are potential economies of scale - which can enhance credit access and reduce cost - from financial institution size

• While it is not clear if the Administration's proposal would cause the break-up of existing firms, the operational disruption from doing so would reduce lending at a time when it is most needed.

There is nothing inherently evil about large financial institutions or their trading activities. The problem arises from poor management of the institutions and their activities and even management selection itself. In pertinent part, many of the problems at large institutions resulted from poorly-conceived purchases of poor quality mortgage-backed securities. Once the poor quality mortgages were made, problems for someone were inevitable. The ultimate source of the problem was the lending and not the securitization. The existing legal framework for oversight of corporations - the ultimate source of guidance for executives and directors, and what should prevent disastrous decisions - is not working properly in the case of large, interconnected institutions.

As recently reaffirmed by the Delaware courts in connection with a case involving Citigroup, there is no legal responsibility for adverse outcomes befalling firms so long as decision-makers, especially boards of directors, did not have an undisclosed direct stake in the outcome, utilized prescribed process and made proper public disclosures of their financial results and circumstances. No matter how much money is lost as a result of poor decisions, its officers and directors are not liable on account of such losses if they acted in good faith, obtained proper inputs from "experts," properly deliberated on the matter and made proper disclosures. One seeking to impose liability in court has the "burden of proof" to affirmatively show that the actions were improper. This emphasis on process and disclosure which is embodied in a legal principle known as the "business judgment rule" is acknowledged by the courts as an effort to promote beneficial risk-taking by shielding decision-makers from personal financial responsibility if their actions were wrong.

To say that we have succeeded at promoting risk-taking is an understatement, but most observers would agree that we must promote entrepreneurial risk-taking in many contexts in order to maintain a vibrant, job-creating economy. Existing law makes good sense where the consequences of a mis-step are confined to the single firm. It is in situations where "innocent bystanders" can be harmed from bad decisions of financial institutions that a different standard is needed. Too many of the financial institution blow-ups were the result of gradual but marked deterioration of lending standards rather than conscious changes in strategy. Boards of directors and senior management must be properly incented to fully understand and control at all times what is going on under them.

Rather than having government with no direct stake in the outcome and no familiarity with the nuances of each situation, enumerate prohibited activities such as proprietary securities trading or financial firms exceeding a certain size, we should align risk and reward. That is, change the corporate law applicable to the largest, most interconnected firms so that their executives and directors, who reap large rewards if their decisions are successful, are potentially liable if their firms incur huge losses requiring governmental assistance or corporate legal liability from management wrongdoing from certain specific activities, irrespective of how they arrived at their decision. The focus is on the outcome instead of the process leading up to such outcomes.

In order to avoid an undesirable chilling effect on lending from such a change, executives and directors should not be strictly liable for all bad outcomes, but should only have the burden of affirmatively showing that their actions were proper - i.e. that they genuinely oversaw management and understood the risks being taken instead of the reverse. It is also essential to avoid holding anyone liable for general business downturns unrelated to their own decisions.

The Administration is right to seek to reduce the need for bailouts by reining in overly aggressive behavior at systemically important institutions, but wrong in its use of an approach that is over and under-inclusive, eliminates certain economies of scale, and does not allow any decision-maker to take into account the specific circumstances which exist. A better alternative exists.