Four Ways to Fix Bank Regulations

BOSTON (TheStreet) -- Most of the problems that led to the global financial meltdown, which first struck 18 months ago, are linked to corporate governance.

Excessive compensation, poor risk controls, opaque financial reporting and lenient boards played a part in allowing the largest U.S. financial institutions to spiral out of control.

Now the government is stepping in after the private sector was unable to police itself. After all, shareholders in Bank of America ( BAC), Citigroup ( C), American Express ( AXP), AIG ( AIG) and Morgan Stanley ( MS) are still suffering from unabashed risk-taking.

While investors of Goldman Sachs ( GS), Wells Fargo ( WFC) and JPMorgan ( JPM) have fared better, governance deficits touch every large financial company.

Regulations that protect shareholders aren't voluntary. The New York Stock Exchange's rules on independent boards and the federal government's financial-reporting standards, bolstered by 2002's Sarbanes-Oxley Act, came about after companies abused their power and, in turn, shareholders. Increased regulations to narrow the gap between shareholder interests and management's goals is inevitable.

Abuses are prevalent across industries and regions, from widget makers in the Midwest to technology companies in Silicon Valley. But the most egregious and systematic infractions have occurred in the financial industry. Thus, banks, brokerages and insurers will be the first to be fixed by the Obama administration and Congress.

The parade of bankers sitting at congressional hearings hasn't stopped. While some of the anger has died down as the country focuses on health-care reform, the fervor is sure to be back before mid-term elections in the fall.

If Congress focuses on four key points, investors would benefit, and the financial system -- and America -- would become stronger.

Independent Boards

A company's board of directors is a proxy for shareholders. It would be impossible for shareholders to vote on every matter, and decisions shouldn't be left solely to management because incentives, both monetary and egotistical, influence their decisions. Boards must be independent of management and advocate for the best interests of shareholders.

NYSE rules say boards must be independent, meaning members aren't also executives of the company or directly involved with partner or related companies. Because of those regulations, all the major financial institutions have independent boards, but other practices that reduce independence, but aren't expressly forbidden, are present.

JPMorgan and Goldman Sachs, for instance, employ chief executive officers who also serve as chairman of the board. This is a clear conflict, as the chairman oversees the board, and the board is supposed to monitor management's moves. A CEO who's also chairman has far too much power in determining the direction of a company.

Bank of America shareholders voted to split the position of chairman and CEO after Ken Lewis steered the company into the rocks during the financial crisis and made matters worse with the acquisition of Merrill Lynch. Morgan Stanley recently separated the jobs, though that was because John Mack retired as CEO. Since Mack retained his position as chairman, it's likely the same issues will occur because he's had an intimate relationship with the investment bank. He's not an "independent director," according to the NYSE, because he's been a company employee within the past three years.

The board is integral to every function of a company and, as a result, the composition of the board is critical to proper governance. Changes to rules regarding proxy statements would go a long way to help avoid conflicts. Currently, investors can vote for a director or withhold their vote, but not against. Shareholders should be allowed to vote against nominated directors and have more access to the nomination process to wield greater shareholder influence.

Executive Pay

Wall Street's chosen few are highly compensated. While some argue that the pay scales are essential to attract and retain top "talent," it's difficult to believe these workers add enough value to justify their gargantuan bonuses. There must be a more efficient use of shareholders' money. Is the supply of capable talent really so thin that salaries of tens of millions of dollars for CEOs are justified? Probably not.

From 1999 to the stock-market peak in 2007, shares of financial companies in the S&P 500 increased by an average annual rate of 7.4%. Energy and consumer-goods companies rose 15% and 6%, respectively. In other words, shareholders underwrote the operations, while top-tier employees raided to coffers and kept the gains for themselves. Financial firms that choose to pay employees in the way that the big investment banks do should never have gone public. Such a compensation structure is better suited to a private partnership.

Wall Street's compensation structure rewards short-term performance with little regard for risk. While those practices are being scrutinized, it's unlikely the payouts will decline. They will simply shift from cash awards to options and stock grants that should align incentives to long-term stock-price appreciation. That's true in theory, but since the risks of losses are still balanced on the other side by the possibility of fantastic gains, greedy employees will still push the envelope. After all, stock options only have value when share prices rise above a predetermined level.

Compensation committees, comprised entirely of independent directors, are responsible for designing pay packages. But it's easy to question committee members' grounding since most board members are executives at other companies who expect huge pay packages of their own.

For instance, JPMorgan's Compensation and Management Development Committee is chaired by Lee R. Raymond, the former CEO of Exxon Mobil ( XOM), who retired in 2005 with a retirement package worth an estimated $400 million. How can someone with an income as large as that be expected to set a reasonable compensation structure for the employees of JPMorgan? A better plan may be to have board members further removed from executive compensation handle the process. For example, Morgan Stanley's Compensation Committee chairman is Erskine Bowles, the president of the University of North Carolina, who makes $425,000 a year, a fraction of Wall Street's titans.

Compensation needs to be tied to risk-adjusted performance. In addition, the entire level needs to be taken down a few notches to pass along more profits to shareholders, the true owners of the company. Even though the process may be inefficient, it would be helpful to make compensation plans for highly paid employees a yearly proxy matter to give shareholders a say.

Risk Controls

Companies keep boards that oversee risk-taking. But those members are viewed, by and large, as whistle-blowers who spoil the party. According to Citigroup's Risk Management Committee charter, the purpose of the group is to assist in the "oversight of Citigroup's risk-management framework, including managing credit, market capital, liquidity and financing risk."

That list should also contain counterparty risk and stricter reporting requirements from all business units, so the committee can analyze firm-wide risk exposure.

Citigroup's risk committee looks like a group that could easily do its job. All five members are finance experts, and the committee even has a former Federal Reserve Bank president, Anthony M. Santomero. Yet, even that board couldn't mitigate risk, likely due to less-than-outstanding information. Thanks to the "garbage in, garbage out" rule of analysis, poor information leads to bad decisions. Had the committee been privy to more in-depth data, the bank's disastrous results may have been avoided.

American Express has structured its committees in a way that leads to the most efficient use of members' specialties. By combining the Audit Committee with the Risk Committee, the credit-card company has ensured that financial experts are behind the companies' risk activities, since the Audit Committee is required to have a financial expert as chairman.

AIG was one of the most notorious violators of proper risk-management practices. The insurer was a backstop for several markets by offering credit default swaps on products that its executives didn't understand. By taking on massive exposure to several counterparties, the risks increased by an astronomical amount. AIG's indiscretions cost U.S. taxpayers about $200 billion in the biggest bailout of a U.S. company.

Regulations that require the disclosure of firm-wide counterparty exposure and asset allocation would help investors and other institutions gauge the relative risk of organizations in a more complete way. While regulations such as the "Volcker Rule" focus on activities like proprietary trading to limit risks, it would be more effective to focus regulation on disclosure. If executives' excessive risks-taking were disclosed, investors would punish the stock, whereas limiting activities tempts executives to get around regulations in new and more outrageous ways.

Rather than allowing "black boxes" to remain on the balance sheets of corporations, enhanced disclosure would allow counterparties to better assess the stability of one another.

Financial Disclosures

Sarbanes-Oxley was the first major step toward increased accountability and disclosure. It took a crisis to cause action then and that may be the same as now.

Recent accounts of Lehman Brothers' accounting shenanigans via the use of Repo 105 contracts must leave investors of other banks uneasy since the Lehman trickery wasn't uncovered until the firm went belly up. Had financial reporting requirements been more stringent, it's likely that Lehman Brothers would have been caught red-handed long before the company collapsed.

Providing greater transparency allows markets to function better since more information means more efficient prices. Also, counterparty due diligence would prove to be much faster, cheaper and higher in quality. The banks wouldn't need to disclose exact positions, but counterparty exposure, detailed asset allocations and general measures of risk such as value at risk, downside deviation and liquidity figures would all greatly improve the markets.

All financial firms are guilty of failing to make things easy. Anyone who has tried to parse a Goldman Sachs, Bank of America or Morgan Stanley 10-K reports can attest to the lack of a clear and easily understandable picture of risks facing the companies. SFAS 157, which requires companies to place assets into one of three categories based on valuation, has helped to improve banks' financial statements, but there is still a long way to go. An average investor should be able to read a financial statement and get a reasonable idea of risks. That's not the case now.

The Obama administration and Congress have said they want to shield taxpayers from banking crises. If that's the case, the answer is to make banks' activities more transparent. Sometimes you don't want to know how the sausage is made, but given that the financial crisis dragged down the stock market by more than 50% and 7 million Americans lost their job in the ensuing recession, it would be irresponsible not to take a deeper look.

-- Reported by David MacDougall in Boston.

Prior to joining TheStreet Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level III CFA candidate.

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