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Friday, March 25, 2011

Bob Pozen: Too Big to Save? How to Fix the U.S. Financial System

Motley Fool Conversations podcast (audio, 24 min).
Bob Pozen is the author of Too Big to Save? How to Fix the U.S. Financial System, the former chairman of MFS Investment Management, and a senior lecturer at Harvard Business School. This podcast is full of amazingly common sense (or provocative) ideas on how to improve the financial system. A few highlights are below.
Do not bail out too many institutions. Bail out only the institutions that are critical to the payment system, or those whose failure would have led to multiple other institution failures (a total of 20-30, not 500-600, as was done after 2008).
Have a system to select what to bail out, and do post-bailout reviews to see what works. Before any institution is bailed out, the Treasury Secretary must write down on a piece of paper the reason why it should be bailed out. The decision should be approved by FDIC Chairman and the Chairman of the Federal Reserve. After the bailout, the GAO should review the results.
Break the tyranny of quarterly results. Public companies should not provide quarterly earnings predictions, to focus attention on long-term results. At most, provide earnings predictions for the next 1-2 years, and use a range, not a single number.
Use professional boards of directors. Independent directors are not enough, if they lack expertise. Most of the directors of public financial companies, especially those for which the taxpayers are the ones left holding the bag, must have specific expertise in that industry. The opposite was true for many financial companies at the center of the crisis (only 1 director of Citigroup had working experience in a financial institution!). Directors must spend a minimum of a 2-3 full days per month in the company, unlike the current practice of 1 day every 2 months. Thus, directors will have enough expertise to hold more meaningful discussions with the executives.
Do not have Congress regulate executive compensation, because this usually has unintended consequences. For example, Wells Fargo worked around the new law that put a cap on CEO bonuses by simply increasing the CEO base salary by several fold. Instead, let the board of directors make the compensation rules. Executive bonuses should be determined by the recent long term (e.g., several years) financial results. At least some of the compensation of higher executives should be in the form of restricted shares (not cash) that vest after another several years, to align the interests of executives and long term investors. Such shares are essentially stock options. Executive compensation should be indexed by the industry group. If the entire industry goes up by 10%, and the company under-performs the industry and goes up only by 5%, the CEO gets a smaller bonus. If the industry goes down by 10%, and the company over-performs the industry and goes down only by 5%, the CEO gets a bigger bonus.
Use leverage and capitalization regulations to make financial institutions safer. The SEC rule of 2004 that allowed investment bank leverage to go up from 15:1 to 30:1 was a bad idea. With a 30:1 leverage, when the market goes down by even a little bit, which historically happens quite often, you have to sell a lot of assets. If everyone sells at the same time, you have a crisis.

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