Wednesday, October 1, 2008

The growing influence of the Fed: Mr. Bernanke, are you willing to be a principal regulator of equities?

Everybody is weighing in on the bailout’s scope and plan specifics. I’d like to add my own basic principles, but focusing more on regulation going forward for pure equity houses.

1. The bailout’s focus should be on addressing the primary sources of the credit crisis, which are the housing and consumer loan defaults. All others, including bank writeoffs and CDO writedowns, are just symptoms of this.

2. The continuing viability of commercial banks, being the primary providers of credit, should therefore be given focus. Investment banks and hedge funds should only be looked at secondarily, to the extent that they may be major counterparties of the commercial banks.

3. Hence, money should not be thrown at saving investment banks and hedge funds per se. If a collapse of a hedge fund could wipe out other investment banks and hedge funds, it should be allowed to fail. If a major investment bank’s collapse can cause major commercial banks to fail, it should be saved. However, investment banks saved this way can and should sacrifice equity. But commercial banks should be capitalized enough to be able to continue providing credit.

4. Credit swaps and other derivatives, transactions that involve commercial banks in a large way, should be regulated. As SEC Chair Chris Cox said, nobody is currently accountable for supervising these transactions.

5. However, investment banks are intermediaries not just in the debt markets, but also in the equity markets. Care should be given that the Fed does not end up regulating activities that are better off left to the market, in other words, equity transactions. Equity investors have a different risk-reward profile from debt investors. Equity investors are willing to put their principal on the line in exchange for a larger potential payoff. Excessive regulation will make equity investment no different from a debt investment. A heavily regulated environment for equities will crowd out investment in greenfield projects and other more arbitrary business activities, which are shunned by commercial banks but necessary to grow the economy in a significant way. Equity transactions in the US are already heavily regulated because of the Sarbanes-Oxley regulations.

6. Because equity investors are willing to put their principal on the line in exchange for a larger potential payoff, see number 3.

7. Now that major investment banks are now under the Fed’s regulatory umbrella, and hence can now access the Fed’s discount window indefinitely, perhaps a new separation a la Glass-Steagall is in order. Carve out all equity activities from investment banks already under the Fed’s jurisdiction. Government should award equity underwriting licenses to entities that will focus just on equities, and not poison the banking system by packaging equity risk back into the commercial banks’ portfolios. These are better off under the SEC’s umbrella.

Not that similar conundrums don't exist anywhere else in the world, but Mr. Bernanke, are you willing to be a more active regulator of equities?

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