Overseeing Finance's New Era

Massive consolidation in financial markets has been underway for some time. Virtually every credit crisis since World War II has spawned further concentration, often followed by new policies that supported deregulation. At the start of this year, before the current crisis was in full swing, the 15 largest U.S. financial institutions had combined assets of $14 trillion, which accounted for more than 40 percent of non-financial debt. Given what we've seen recently, from the government takeover of AIG, Fannie Mae and Freddie Mac, to the disappearance of investment banks as we knew them, such concentration will continue.

The largest conglomerates dominate many areas of trading, underwriting and investment management, and it is increasingly clear that the federal government is ill-equipped to handle their regulation. Indeed, many argue that government measures have contributed to the current woes.

The focus of new supervision and regulation should be on these largest financial institutions -- on how they are governed and on who should provide their credit ratings. To start, we need:

· A new Federal Financial Oversight Authority. The FFOA should be charged with supervising 15 to 25 of the country's largest financial institutions (the existing regulatory apparatus can continue to oversee smaller firms). Its chairman, whose appointment should be subject to congressional approval, should serve as a voting member of the Federal Open Market Committee, which would bring to bear on the nation's monetary authority input about the status of the leading U.S. financial institutions. Too often, central bankers have tended to focus too narrowly on monetary matters while neglecting their role as guardians of our financial system. To further strengthen the FFOA's legitimacy and transparency, its chairman and the Federal Reserve Board chairman should co-sign an annual report to Congress on the safety and soundness of financial institutions under their purview.

Members of the FFOA must be able to assess the adequacy of credit, the soundness of trading practices, firms' vulnerability to conflicts of interest, and overall measures of stability and competitiveness. To attract highly qualified professionals with broad expertise, the government will need to compensate them competitively with the private sector.

· New standards for the management of financial institutions. Financial reporting requirements should be expanded so that institutions assess assets and liabilities within their conglomerate structures, as opposed to within their individual niches as current rules allow. Reports to shareholders should indicate, clearly and prominently, quantities of specific classes of assets and their concentration in specific industries. When firms take write-offs, they should be required to adjust earlier-year earnings downward to give a true picture of their financial performance.

Managers of leading financial institutions should be compensated on the basis of long-term, sustainable profits. Stock option rewards should come with long maturities and should not be executable upon termination. Nor should end-of-service contractual cash settlements be paid at time of termination, and those should include provisions in which the company could get, or "claw back," such funds.

Board members should also be subject to tougher standards. Their qualifications should include sound working knowledge of accounting as well as literacy with quantitative risk analysis techniques and proficiency with information technology. Directors should be assessing information streams that include unvarnished data and candid analysis of the scale and scope of transactions with affiliated companies and of assets and debts transferred to (off-balance-sheet) special-purpose entities.

As new board members are elected, they should meet with regulators to understand how the board's responsibilities are viewed. Thereafter, new directors should join seasoned board members in regular meetings with regulators to review the results of examinations and to discuss FFOA recommendations and compliance. Independent directors should hold separate, periodic meetings on growth aspirations, risk policies, succession planning and other critical issues.

· Credit rating by official supervisors. Private credit-rating agencies simply are not up to the task of issuing accurate and timely ratings for the largest financial conglomerates. There is precedent for this at the Federal Reserve, which currently issues credit, assets, management, earnings and liquidity ratings for many of the institutions it oversees.

· Cooperative supervision of large foreign financial institutions. In modern finance, transnational cooperation is essential. If central banks and other supervisory institutions in leading global economies embrace a similar approach, steps toward more effective supervision will simply work better. As in the United States, relatively few financial institutions would be subject to new supervision -- the five to 20 largest, most diversified institutions in each leading economy. The financial giants in the European Union, Canada and Japan should be subject to the most rigorous oversight. Moreover, regulators of leading firms in those nations would need to cooperate closely to achieve coherent, unified supervision.

The Basle Agreements guiding bank capital simply are not comprehensive enough to meet the challenges of today's globalized financial markets. Our government, working in concert with other large economies, must take steps to effectively regulate the few conglomerates that hold such sway over our financial markets. Otherwise, the current crisis will be a prologue to even a bigger one.

The writer is president of Henry Kaufman and Co. and the author of "On Money and Markets: A Wall Street Memoir."