Last week, the Senate of the United States joined with the House of Representatives to adopt legislation reforming financial practices in the Unites States. President Obama signed the legislation on July 21st.
Adopted in response to the failure of the financial industry to maintain credit markets in the fall of 2008, the legislation proposed changes in laws and regulation to prevent similar crises in the future.
The legislation, important and forward-looking, only partially implements the recommendations of the Caux Round Table proposed in October 2008 and so leaves global capitalism exposed to suffer from similar market failures in the future.
In its analysis of the causes of the meltdown in financial markets, the CRT noted as the principal failure inadequate checks and balances on the risks assumed by financial firms. These constraints on irresponsible assumption of risk in speculative frenzies come both from without the industry – from government and consumers - and from within.
The more important checks against systematic risk of market failure, frankly, must come from within the industry put in place by enlightened self interest on the part of firms, realistic market pricing of financial instruments, and cultures of prudential governance.
In this regard, the CRT recommended:
- Require board directors to consider interests beyond shareholders, which may affect the company’s success, by codifying the principle of “enlightened shareholder value” in company law
- Require minimum standards of corporate governance knowledge and expertise for corporate board directors.
- Require corporate boards to have a dedicated board committee responsible for risk oversight across the full spectrum of risks - financial, governance, social, environmental.
- Regulate executive remuneration structures to ensure that they are consistent with prudent risk management, align with long-term wealth creation, and do not reward poor performance.
The only part of the recent legislation that seems to address these concerns is the establishment of a new regulatory body to set forth rules for consumer financial contracts. The rules, it is presumed, will forestall selling to consumers contracts for borrowing that are unfair, oppressive, misleading, manipulative, hard- to-understand, or which disproportionally place risk of loss on the consumer.
Otherwise, the legislation just adopted by the United States chose not to provide rules for such internal governance of financial firms. It chose instead to address first and foremost another consequence of the market’s failure: public bailouts of firms that had made stupid business decisions. This problem is that posed by private firms considered “too big to fail”. If such firms are allowed to crash, markets will respond with panic and so precipitate economic collapse as asset values fall and credit evaporates. The people at large, especially the most vulnerable, then suffer direct economic harm. Government then must spend public money to support asset prices and keep credit markets open, preventing recession or worse.
Financial markets should not be so allowed to fail. When they do, public resources are diverted from other uses, public debts increase to be later funded with higher taxes or inflation. Such public spending is, at bottom, a waste of public money, forced on governments by imprudent private sector behavior to preserve necessary public advantages in open and robust financial markets.
The CRT in its recommendations addressed this problem as follows:
- Implement stronger and globally co-ordinated financial and banking regulatory reforms to prevent systemic risk build-up or market manipulation.
- Regulate all financial markets instruments and investment activities that materially impact on financial system stability and on superannuation and pension system viability.
- Reform and adequately resource the IMF and other multilateral institutions to ensure they are effective forces for economic and social justice globally.
The recent US legislation takes important steps along these lines.
First, it sets up a procedure for prudently closing down failed financial firms. The government is now authorized to step in when large firms overextend themselves and create risk of market turbulence and panic. The government can seize and break up such firms, liquidating their assets slowly so as not to create a fire sale and collapsing asset prices and paying off their debts as best as can be done given the firms’ distressed circumstances. Large firms with influence across markets are now required to prepare “living wills” or schedules of assets and liabilities to expedite the process of winding up such firms: selling the assets to pay the liabilities. The costs of closing such failed firms, including losses in the process, is to be charged to other financial firms and not to the government and the taxpayers. The Federal Reserve Bank is given power to more closely regulate such big firms in advance of their becoming dysfunctional while itself being subject to more public scrutiny.
This package of inter-related reforms provides relief consistent with one of the CRT’s recommendations.
Reforms at the global or international level, as also recommended, are still slow in coming.
Second, several practices that led to excessive speculation and “irrational exuberance” in the run-up to the 2008 meltdown have been prohibited: banks will be limited in the extent they can use their own funds for speculative trading in financial instruments. Such trading is to be placed in the hands of firms that can go bankrupt with disrupting credit markets. Their market failures will be costly mostly to themselves. Banking profits will go down as the sanctity of their capital reserves will go up.
Trading firms that overextended themselves must not register with the Securities and Exchange Commission and make more public the scope and nature of their buying and selling. The SEC will then, it is hoped, be in a position to use regulations to curb self-serving but risky practices brought to market by such firms.
In line with the market management philosophy that knowledge of material facts leads to better pricing, disclosure of transactions in derivatives is now mandated. Financial contracts which are little more than bets on future contingencies must be cleared in a public market so that knowledge of terms, prices, and risks assumed will be widely available to all traders.
New requirements for companies that rate financial instruments (Moody’s, S&P, and Fitch principally) will bring more transparency to the valuation process used to support ratings. This will constraint the ability of such firms to “sell” ratings which are unsound and misleading to investors about the risks involved in purchasing financial instruments.
Finally in this regard the new legislation established a financial stability oversight council which will look for the accumulation of risks threatening market stability. The Treasury will have a new office of research and the Federal Reserve System will have a new vice-chairman to focus on enhanced supervision.
These reforms go in the direction recommended by the CRT of changing risk management practices within firms, starting with enhancing board responsibility for comprehensive risk management.
Until the risks of enterprise are more fully expressed in valuations of business practices and the financial instruments that permit participation in such practices financial markets will be vulnerable to the growth and the “popping” of asset bubbles as “irrational exuberance”, speculation in trading, herd instincts, and other market forces once again push up values beyond where they can be sustained. Forcing more transparency and competition in the rating of debt instruments as the new reform legislation does ill contribute some increased sanity to markets. But as long as ratings are driven by those who sell such instruments, the bias of “hyping” valuations to please sellers and con buyers will continue.
Until the problem of valuation is brought under control, global capitalism will be subject to dysfunctional fits of indulgence followed by loss and remorse.
We hope progress can soon be made on this agenda as well.
Contact for further comment:
Stephen Young, Global Executive Director, Caux Round Table
Phone: +1 651 223 2852 (office) or +1 651 336-4812 (mobile)
About the Caux Round Table
The Caux Round Table (CRT) is an international network of business and professional leaders working to promote a moral capitalism since 1986. The CRT advocates implementation of the CRT Principles for Responsible Business through which capitalism can flourish and sustainable and socially responsible prosperity can become the foundation for a fair, free and transparent global society.
Uniquely, the Caux Round Table (CRT) Principles for Responsible Business provide strategic ethical guidance which, had it been followed, would have kept those institutions that have triggered the Global Financial Crisis more faithful to their obligations of stewardship, good governance and stakeholder risk management.
The CRT Principles for Responsible Business go to the heart of constructive and ethical behaviors that enhance risk assessment and stakeholder management, boosting bottom-line valuations of business success and sustaining responsible long-term wealth creation for society.
The CRT Principles for Responsible Business can be accessed at http://www.cauxroundtable.org
The Principle of Enlightened Shareholder Value
The Principle of Enlightened Shareholder Value imposes obligation on directors to achieve the success of the company for the benefit of the shareholders by taking proper account of all the relevant considerations for that purpose including:
- a proper balanced view of the short and long term;
- the need to sustain effective ongoing relationships with employees, customers, suppliers and others;
- the need to maintain the company’s reputation; and
- the need to consider the impact of the company’s operations on the community and the environment.