The calendar says 2010, but Frank Partnoy believes that in certain respects, we’re living like it’s 1931. That was a transitional year between the 1929 stock market crash and the passing of two transformative securities laws, in 1933 and 1934, that established a regulatory body for public companies, mandated widespread financial reporting, and created antifraud remedies.
Seven decades later, optimists would like to believe that the regulatory reform bill in Congress will mark the beginning of better days for the U.S. economy. But Partnoy, a University of San Diego law and finance professor and longtime follower of regulatory reforms, thinks 2010 will likewise be considered a transitional time. “We’re still in the middle of the ball game in terms of regulatory response,” he told CFO in a recent interview.
In Partnoy’s view, the regulatory response to the financial crisis thus far has been “muddled.” Congress is plodding through more than 1,500 pages of reforms that will affect various areas of the U.S. financial system. The reforms include a new government authority to prevent financial institutions from becoming too big to fail, a consumer protection agency, regulations for the derivatives market, and even some measures that could be deemed antiregulation (such as a provision that would exempt the smallest U.S. publicly traded companies from getting an audit opinion on their internal controls).
The bill is expected to be finalized at the end of this month. Around the same time, Partnoy will speak about the new regulatory reforms and their resemblance to past reforms at the upcoming CFO Core Concerns Conference, to be held June 27-29 in Baltimore. An edited version of CFO’s recent interview with Partnoy follows.
How can we assess whether the new legislation will be successful?
The only way we’ll know is to wait and hope. If we could go back in time a few years with these proposed rules, would the crisis have been prevented? The answer is no. Congress is considering more than 1,500 pages of reform, but most of that is not directed at problems that would have prevented the crisis.
What piece of the legislation do you most hope will survive the process?
The most crucial part is the removal of regulatory references to credit ratings. I have my fingers crossed that it will pass. Participants in the financial markets need to stop relying on Moody’s and S&P.
Why isn’t a similar proposal by the Securities and Exchange Commission to end the practice good enough?
The SEC doesn’t have the power to change a statute; Congress does. And many of these references extend beyond the securities area, outside the purview of the SEC. In addition, it’s important for Congress to fire a shot across the bow of all regulators to let them know that it’s not appropriate to rely on ratings. It’s the kind of reform that needs to come from the top, and that means Congress.
In a joint paper with former SEC chief accountant Lynn Turner, you called on Congress to “clarify that financial statements have primacy over footnotes, not the other way around.” Why do you think our financial-reporting system has evolved to become, in your view, not as transparent as it should be?
It’s been a slow evolution that has been driven by lobbying, in particular by major financial institutions. This started in the 1980s, when accounting standard-setters were trying to figure out whether swaps should be accounted for on the balance sheet. Once that argument was lost — once we went down the road of saying that swaps were different — it was a very slippery slope. There’s a focused group of market participants who benefit from off-balance-sheet treatment but only a few who represent investor interests. Analysts are in an interesting position because on the one hand, they would be able to do a better job if they had more information about exposures and liabilities. But if everything is off-balance-sheet, they have a comparative advantage in finding out what’s buried on page 246 of Form 10-K.
Do you see any signs that this issue will be addressed in the legislation?
Congress, Wall Street, and large institutional investors all seem to have united against putting these financial instruments on the balance sheet. It seems unlikely that there will be any kind of substantive change.
What’s your view on proposed reforms for derivatives?
What I regard as the most important reform has met with mixed reactions. That would be simply for banks to more accurately report their exposure to derivatives and give better information about worst-case scenarios. Those initiatives have taken a back seat to the push for requiring that derivatives be traded on exchanges, and then for trying to move derivatives outside of the banking sector. Keep in mind, the transactions that generated the crisis were not transactions that would ever find a home on an exchange. They’re private, custom-tailored deals that fall outside of the legislation. Paradoxically, we might end up with a law that will hurt useful markets in plain-vanilla derivatives, yet will not resolve problems.
Has there been a proper balance between the need for reform and the need for banks to be able to lend to corporations?
Just as it’s problematic when banks extend too much or too easy credit to individuals, creating a credit bubble, the same kinds of things can happen with companies. I’m not sure that this financial reform will dramatically increase corporate borrowing costs. Some people have raised that as a significant problem and it may be true, by making certain kinds of credit more expensive under the consumer-protection side of the legislation. But I don’t see it as being a disastrous, sky-is-falling scenario for companies.
Is it realistic to hope that regulatory reform, done properly, could prevent another crisis from happening again?
I don’t think there’s any way to eliminate these crises. Historically we’ve always had them, and we always will. We can use the regulatory system to try to dampen them and then prolong the steady growth periods that follow. We had several decades of solid growth with a robust, strong financial and regulatory system after the last major crisis in 1929. It was only during the past 15 years that the financial system has become unmoored and out of control. If we understood the causes of interconnected crises, it’s possible to address them through financial reform and buy ourselves another round of decades of robust economic growth. But I’m afraid we’re not doing that with this legislation.
So you think we’ll see more rounds of regulatory reform in the near future?
I think we’ll see this legislation pass. Then either that will be it, or another major shoe will drop in the next year or so.