Financial Deregulation

Washington Post business columnist Steven Pearlstein was online Wednesday, Nov. 22 at 11 a.m. ET to discuss recent remarks by Treasury Secretary Henry Paulson.

Is encouraging competition with London and Hong Kong merely a convenient excuse to justify deregulation of the nation's financial regulatory structure? Read today's column: Paulson May Find Sensible Doesn't Sell.

Submit a question or comment now or during the discussion.

For more information about Paulson's remarks, read: Paulson Says Business Is Over-Regulated: Treasury Chief Still Backs Sarbanes-Oxley (By Carrie Johnson, Nov. 21).

About Pearlstein: Steven Pearlstein writes about business and the economy for The Washington Post. His journalism career includes editing roles at The Post and Inc. magazine. He was founding publisher and editor of The Boston Observer, a monthly journal of liberal opinion. He got his start in journalism reporting for two New Hampshire newspapers -- the Concord Monitor and the Foster's Daily Democrat. Pearlstein has also worked as a television news reporter and a congressional staffer.

His column archive is online here.

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Wooster, Ohio: Thanks for your thoughtful comments today. Speaking as a good capitalist and a former Republican, I think you hit all the right notes. I'm thinking that Paulsen and the Dems (Barney Frank has been saying some good things) may actually be able to negotiate their way to some improved solutions over the next 2 years, in a way that I would never trust the Republicans - too often in the pocket of the US Chamber - to be able to do. Do I have reason to hope?

Steven Pearlstein: Yes, you have reason to hope for just the reason you state: Dems and some important outside interests would not trust the Republicans to do this because it would be done in a very one-sided way, to the detriment of investors, consumers. But the issues are real, nonetheless, and I'm sure people like Barney Frank, Chris Dodd and Paulson can do a deal if they want to. What it requries is for Paulson and the Republicans to get the business community to think hard about what are the genuine problems and be willing to settle for modest, practical solutions.

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Annapolis, Md.: Steve--you usually get it more or less right but you sort of messed up on this one in one major respect.

You stated:

""But it is equally plausible that what we're seeing is the inevitable end to near-monopoly that has allowed U.S. financial firms to charge outrageous fees and earn outsized salaries and bonuses. A more seasoned Washington hand would have taken care to point out that if government has no business protecting the jobs of auto workers who price themselves out of world markets, it certainly has no business protecting millionaire investment bankers and hedge-fund managers.""

If you did your homework you would have learned that it is the US investment banks that are cashing in on the London IPOs and offshore deals--- and big.

In other words "Wall Street" as embodied by the very large US investment banks (as inferred in your article) are completely indifferent as to WHERE these deals are done, be it the NYSE, LSE or in Singapore, Amsterdam and Hong Kong. They make just as much if not more. It just that their European/ Asian bankers may make a bigger bonus, but believe me the NY bankers also do very well.

One might still accurately argue that it is in America's best interest to have the world's best, largest futures options and stock exchanges and US based multinationals.

The wealth does flow back to the US and it has a better chance of working it

s way back into the US economy through things like NYC and NYS tax receipts, vendors, subcontractors, US housing etc etc.

Keep trying!

D.

Steven Pearlstein: No doubt about what you say: the investment banks in London are largely the same as here. But there is no doubt about what I say: there is precious little price competition in this oligolopolistic industry, which is why they earn rents and pay outsized salaries to their employees in ways that demonstrate an imperfectly competitive market. So how do we reconcile these two truths? Well, I think it a reasonable proposition that a better way to inject some competition into this marketplace is to have competition from different countries with different cost structures and business cultures. Maybe they will just join the oligarchy, and agree not to compete on the basis of price. But the chances of maintaining oligopoly pricing are reduced as the number of players increases, and more trading centers is a way to open the possibility for more players. It won't necessarily happen right away. But it increases the odds.

Your argument, at the end, is essentially, what's good for Merrill Lynch and its New York operations is good for America. What you neglect is whether this oligopoly raises the price of raising capital in the U.s. for U.S. firms, and thereby raising prices of other goods and services here and deterring job creation. So you were only considering one side of the matter, which is how the industry prefers to frame this issue.

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Indinapolis, Ind.: I think we need to be careful of Paulson's own natural biases. A person who has made hundreds of millions of dollars in any system, tends to think the system is fair overall. There is a bias in everything he said yesterday to isolate to a few bad players the harm that has occurred, and to respond with unenforceable remedies based on "principles." He is ignoring symptoms that need attention. He, the Chamber of Commerce and the accounting firms, want to call attention to the "Thompson Memo" and study it, revise it, etc. The fact is, it doesn't say anything. Meanwhile, executive compensation is uncontrolled and financial statement obfuscation continues, as industry consolidates its way through the positive effects of a competitive system to a system of trusts. The trusts treat human capital as expendable inventory, obsolescing most participants before a full, natural life. Time wasted rehashing the Thompson memo could be better spent revisiting the objectives of antitrust legislation that is totally ignored, to be sure we don't repeat mistakes of history.

Steven Pearlstein: Well, there's a lot there. Let me explain to those who don't know that the Thompson Memo basically told companies that if they provide legal fees to their employees who are subject of investigation for things like accounting fraud, it may be a factor when the department considers whether to indict the corporation. Some consider this too big a stick to wield against companies, with the effect of denying employees a reasonable chance at being adequately represented by counsel. I've thought about this a bit and think maybe there would be no great harm to rescinding the memo, because prosecutors still have wide discretion in bringing criminal acdtions against a company anyway. In those cases where the legal fees are really hush money, designed to make sure some employees don't rat on the company and the CEO, prosecutors can still go after the company. But to do so, they would have to make a more detailed case to the head office, which is probably a good thing. Arthur Andersen and all that.

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Danvers, Mass.: Yes to directors needing a majority of the shares and shareholder vote on management pay. Similarly, how much could be accomplished by restoring liability to auditors?

Steven Pearlstein: Well, auditors think they already have too much liability, and are being used as insurers of last resort when companies are discovered to have defrauded investors. I'm not prepared to let them off the hook completely, which is what they want in their heart of hearts. But you might be able to structure some caps for damages that reflect the degree of negligence and culpability, as some multiple of the engagement fee. If the fee is $4 million, and the company knowingly conspired with management to withhold information from shareholders, however, I don't see why the company shouldn't be liable for 100 times the engagement fee in the case of a huge corporation where investors lost billions of dollars. On the other hand, if the facts show that the auditors were thorough and conscientious but just bamboozled by the company, then there is no reason why they should be liable for more than, say, 5 times the engagement fee. You don't want to make it too low because, otherwise, there is really no disincentive for auditors to become tools of management and directors (who are not always good representatives of the interest of shareholders). So you need to have some stick in there.

By the way, you also need to have some accountants lose their license when they get involved in Enron type behavior. Has this happened? I don't think so. And its a real disgrace.

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Tampa, Fla.: The business community is greatly overplaying the added burdens of SOX, especially section 404 and internal controls. If section 404 is so much overkill, why did the stock option backdating seemingly stop when section 404 became effective? Why have the restatements stopped? If they haven't, if they've continued after the effective date of SOX and section 404, then SOX and section 404 are not strong enough.

Moreover, the complaints about cost are ill-founded as well. Accounting systems, whether used for GAAP or tax, typically cost much more to implement than to run. Most of the costs are incurred upfront, and then the costs drop significantly once the system is implemented. So complaints about the costs of implementing realistic internal controls do not recognize the reality of accounting systems. It would make no sense at all to throw away all these sunk costs when the on-going costs are so small in comparison.

And let's not forget that business really has no complaints about complexity. LIFO (Last-In, First-Out inventory accounting) is a perfect example. LIFO is mind-numbingly complex. Setting up a LIFO inventory system not only requires substantial up-front costs, but also substantial on-going costs. Companies using LIFO have to keep records going back to Day 1--even if that was 1929.

Yet when Congress considered repealing LIFO to tax purposes earlier this year, business howled. They came up with all sorts of lame excuses. It would reduce our competitiveness, blah blah blah. What they really meant was that it would increase their tax bill. No amount of complexity is too much for that! Yet section 404 is oh so hard. Gimmee a break!

Ask those CEOs and lobbyists (like the Chamber of Commerce) if they'd accept weakening SOX if they also had to give up LIFO. I think the answer would be no.

Of course, business doesn't really like LIFO for anything but tax. The entire justification for putting LIFO in the Internal Revenue Code is that it's good accounting--it's GAAP. Yet they successfully lobbied the Treasury Dep't to overrule the book/tax conformity required by Congress. It would reduce EPS and thus the value of stock options.

Also, keep in mind that the average company spends less on SOX than they pay their CEO.

SOX is a small reason for London having the lead in IPOs and the success of private equity firms. Investment banking fees are 50% lower in London than in NY. The pool of capital in London has finally caught up, if not surpassed, that in NY. Companies are going private because the there is so much money in PE chasing so few deals that the PE firms can overpay. Plus Delaware corporate law allows management to take much of the benefits from shareholders, so management comes out on top, as always.

Finally, remember that SOX finally gave the auditors at the Final 4 accounting firms a chance to make money on their own, as opposed to being loss leaders for tax and consulting. Audit fees were long under priced. Now with most of the non-audit work banned, audits are being priced realistically. This explains most of their increase.

SOX is simply an excuse, not a reason. Paulson is simply carrying water for Wall St and the Wahabbi capitalism crowd (Cato, Heritage, Club for Growth, etc).

Steven Pearlstein: You've put your side very well indeed, with lots of good points. I've made a few of them myself in recent weeks. I do want to pick up on one thing you said, which is about Delaware incorporation and Delaware corporate law. Paulson and the business community have made a credible argument that its a bit unfair for global corporations based in the U.s. to be subject to regulation not only by a variety of federal agencies, but also by 50 state attorneys general. The subtext of this, of course, is that Eliot Spitzer went way too far and the SEC should have preempted his prosecutions, civil and criminal. I can see the logic there, just as I am aware that without his actions, a lot of reform wouldn't have happened.

But I think it fair to point out that a corporate community taht wants to federalize regulation of financial services can't turn around and argue that it can go shopping among the 50 states for the most favorable corporate law (Delaware). Companies that get the benefit of a single federal regulator ought to be required to take a single, federal charter, which strkes a better balance between shareholders and management. And this would get around a lot of the problems the SEC has with regulating the behavior and governance of public companies.

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Paulson and William of Occam: Steven,

Isn't it more likely that Paulson is just going to follow Republican tradion of "just carrying water for moneyed interests"? He said what he said, omitted what he omitted.

William of Occam would have just applied his razor and taken it for what was given, rather than develop a tortured "he really mean good things those who appointed him oppose, but just doesn't know how to say it yet".

Steven Pearlstein: I spent some time with him, and some of the people around him, and I came to a different conclusion. But it is only a hunch, albeit an educated one.

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D.C.: Your column mentions personal accounts without diverting Social Security taxes -- how is that different from 401(k)s/IRAs?

Steven Pearlstein: I don't think my column does mention that, actually. But the shape of a grand bargain on SS is pretty clear: leave the program structured as it is, with tweeks to the taxes and benefits and cost of living adjustors to make it solvent again. And then bring together all the various tax-advantaged savings schemes into a single regime, to get people in the habit of supplementing SS with other savings.

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Wooster, Ohio: Thanks for your response. You stated that: "What it requries is for Paulson and the Republicans to get the business community to think hard about what are the genuine problems and be willing to settle for modest, practical solutions." But what Repub's will work for this? And how do you get past the Chamber? Can the Accountants help?

Steven Pearlstein: You get passed the Chamber only if they know the administration is willing to work with the Democrats to fix the problem in a balanced way. You have to make it clear that you are going forward with them or without them -- but that they would be better off with the former.

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McLean, Va.: The globalization pressures (agreements) trump the national economic policy/regulatory design of any single nation. I predict that in ten years our world will have changed enormously given the programs and standards implemented by NAFTA, the WTO, the World Economic Forum, the EU, and APEC in concert with NGOs.

In our hemisphere, the US, Mexico and Canada will operate much like the EU. I wouldn't be surprised if we even shared a uniform currency like the euro-dollar. I can easily see some very big changes in our regulatory infrastructure as we edge towards international standards. I just hope that the drivers of this train know what they are doing.

Steven Pearlstein: Me, too. The Basel agreement on bank capital standards is an example of the internationalization of regulation, and it is turning into a big fight here. The banks pushed hard for a new set of standards that essentially allow each bank to set its own capital standards, based on their own risk models. And you won't be surprised to learn that these models would, on average, allow them to reduce the amount of capital they are required to hold against their assets by 20 percent or more. Now US regulators, particularly the FDIC, say they are quite happy to allow more flexibile, risk adjusted capital standards. But they want a flexible system that, at least at the start, maintains current capital levels. So they want to put a floor under the formula. And the banks are screaming bloody murder. The banks will win int he end on this, unless congress intervenes, because the Federal Reserve will cave to the banks, as it always does. But it is a warning to us all that if we get into these international regulatory regimes, we better do it with our eyes open. They may be more susceptible to regulatory capture, not less.

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Indianapolis, Ind.: With due respect, you've mischaracterized the Thompson memo. It simply says DOJ can prosecute a company if it does something wrong, without regard to collateral damage. As a policy statement, it's meaningless. Thompson's contribution was minor grammatical changes to an old DOJ memo, and his grammatical edits came after Andersen was prosecuted, when the DOJ was trying to justify why it put the company out of business before the trial. The point is, wasting time on the Thompson memo shifts attention from anti-competitive behavior.

Steven Pearlstein: When I hear people talk about the Thompson memo, it is in the context of legal fees for employees....

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Kansas City, Mo.: Within the last few months there have been a few articles regarding a committee formed to study America's declining international competitiveness in regards to investment banking and publicly traded companies in general. Could you tell me more about this committee's work as well as how this may have an impact on Secretary Paulson's remarks? Thank you.

Steven Pearlstein: The committee's work is part and parcel of Paulson's effort. It is headed by Hal Scott, a respected Harvard Business School (or is it law school) professor, and Glen Hubbard, the dean of the Columbia Business School and a Bush economic adviser. But there are lots of good people involved, like Bob Litan, who lives there in Kansas City now and headed the Brookings economics department, and Jack Coffee, the very reform minded professor of securities law at Columbia, and Bob Glauber, who takes a corporate view on most things but is intellectually honest. Their report is expected out next week, and we'll see how one-sided it is or isn't. My guess is that it will have some fairly reasonable recommendations on how to make regulation more efficient and less onerous without giving up too much by way of investor protection. It will come down hard on the torty system, which it should, because that is probably the biggest negative factor in terms of competitiveness. But what I think it will avoid is trying to push forward with other needed corporate reforms, like the need for directors to win majority votes, which will be a lost opportunity and would make the whole package more balanced.

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Hancock, Maine: Hi Steven,

I'm a bit confused. You seem to think that Paulson is using terminology and rhetoric that he himself doesn't fully embrace - why do you think he doesn't embrace it?

He seems, to me, be like he's falling pretty much in line with coporate interests. Am I wrong? When some one talks about a "non-rules based" approach to deregulation I have to chuckle.

Steven Pearlstein: No, the language he uses is perfectly reasonable. The only problem is that this reasonable rhetoric was long ago captured by business interests, who use it as a smokescreen for doing much more radical things in rolling back regulation. And Paulson, who is new to town, seems to be unaware of that. I'm sorry that didn't come through more clearly in the column.

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Steven Pearlstein: That just about wraps it up, folks. Have a wonderful Thanksgiving. See you here next week.

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Vero Beach, Fla.: London seems to have been transformed by wealth from the financial services industry since the stock exchange was reformed in the "big bang" of 1986. Not to mention that the city has become a highly desirable place for affluent people to live. It would be a terrible loss for the US if our regulatory environment caused us to lose financial activities to other countries.

Secretary Paulson has a chance to leave a major legacy for the Administration.

Steven Pearlstein: Ah, one last question. Well, it would be a shame if our regulatory environment cased us to lose these activities, although it is not proven that this is the major driving force. It is a factor, but maybe not the biggest. And it may be that some loss of market share is inevitable, considering how dominant we were. Let's not confuse loss of market share with declining business. The global pie is growing very fast. Finally, as I said, let's not forget that the purpose of the exercise isn't just to protect jobs here in the U.S. It is to get better value for the financial services we purchase. Global competition has proven to be a good way to insure we get better value in cars, shoes, clothing, etc., Why not financial services? Maybe Wall Street needs a good competitive kick in the pants.

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