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Sunday, April 16, 2017

Have Business Schools Ruined Capitalism?

By Roy C. Smith

Ross Sorkin’s review of The Golden Passport by Duff MacDonald raises again the question of whether Harvard Business School (and all other business schools) should be blamed for the ethical hollowing out of modern capitalism. 

Apparently MacDonald thinks so, according to the review, because in 1985 HBS hired Michael Jensen, a Chicago-trained, free-market economist from the University of Rochester, who then refocused the school’s notion of the purpose of capitalism from efficient manufacturing to maximizing shareholder value.

Michael Jensen, now an Emeritus Professor at HBS, was undoubtedly one of the more influential business school professors of his day. His seminal work on agency conflicts helped illuminate a lot of the darker niches of corporate governance in the 1970s and early 1980s when, after a decade of underperformance, American corporations attracted a tidal wave of takeovers (25% hostile) that brought the shareholder value movement to light.

It began with the “rogues” of corporate finance (hostile activists, “asset-strippers,” “greenmailers,” leveraged buyout firms, and financial entrepreneurs generally) threatening large, long established corporations with takeover offers made directly to their shareholders, bypassing management.

At first these aggressive outsiders were seen to be disruptive influences, driven only by greed to make trouble for “great American corporations,” whose management, it was assumed of course, had the best interests of shareholders at heart.

The rogues, however, explained their actions by saying that management had destroyed shareholder value through a series of mistaken actions authorized by Boards of Directors that were unchallenged by shareholders. Whenever a challenge did arise, they added, CEOs and their captive boards of directors, were able to squash it with impunity.

It didn’t take long for institutional investors that cumulatively owned controlling positions in the targeted companies to work out that the rogues had a point. In too many cases, so-called great American corporations had fallen into economic disrepair by failing to remain competitive and adapting to changes in their markets. The market capitalization of US corporations slumped in the 1970s (to less than that of Japanese corporations). It became clear that US corporations needed to be revitalized and restructured, but so did the mechanism of corporate governance of public companies with widely distributed shareholdings.

HBS in the 1980s was closely tied to many great American corporations through its case method of teaching (requiring cases to be written with the cooperation of the corporations), executive training, job-placement and fund raising.  But it was also expanding its notion of business education to include financial services and investing institutions, and Jensen’s arrival helped to create a platform for scholarly examination of some of the issues that emerged with the takeover boom.

One of these issues, in which Jensen specialized, was agency conflict, i.e., the conflicts of interest that are inherently present in relations between shareholders (owners) and managers (agents). Owners, of course want to see the maximization of value of their investment over time and after taking business risks and obligations into account. Owners are represented by Boards of Directors, but boards could be dominated by CEOs. CEOs, however, are not owners but agents hired to run the company on behalf of owners. Some agents see their role as maximizing the stock price over relatively short periods of time, regardless of risks and obligations, so as to profit from incentive compensation arrangements. 

Throughout the 1980s (and ever since), agency conflicts involving takeovers and control issues have been litigated extensively in the Delaware Chancery Court, resulting in a well illuminated but continuously updated pathway of what is permissible and what was not in launching and defending against unwanted takeover efforts.

At the same time, a different form of corporate organization was emerging to improve operational efficiency and to maximize returns to investors. This was the leveraged buyout in which an investor group would acquire control of a corporation, leverage its balance sheet to increase shareholder returns and then manage the enterprise to maximize value and minimize risks. There was very little agency conflict in these organizations – the ownership was concentrated into a powerful, knowledgeable group that hired managers but watched them very closely and made all the important decisions. 

Jensen was certainly important in bringing attention to these issues in corporate governance, and bringing HBS into the field.  But he was by no means alone.  At Stern, a number of finance professors, including Yakov Amihud, Edward Altman, William Allen, David Yermack, Aswath Damodaran, Ingo Walter and myself, authored books and papers on various aspects of these issues, contributing to a wider national effort to better understand and balance-out the roles of Boards and managers.  

The Golden Passport, aims to persuade readers that despite its great success in recruiting great students and faculty, and in maintaining important working relationships with corporations, it has lost its soul to corporate greed and recklessness epitomized by an overwhelming emphasis on maximizing shareholder value above all else. This is absurd - neither Harvard not any other business school has done that.

On the contrary, business schools such as HBS and Stern have contributed knowledge and insight into how corporations maintain their competitiveness, the pros and cons of takeovers, how leveraged buyouts should be structured to work best, and how corporate boards and their critics can agree on practical ways to minimize agency conflicts going forward.

These are important contributions and we should be proud on them.

Note: The author is a graduate of HBS.

Thursday, April 6, 2017

The Re-Birth of Citigroup

by Roy C. Smith

The Economist recently observed that “Citigroup’s decade of agony is almost over,” and now all it needs to is be able to demonstrate that it can grow again. That will not be so easy. After a decade of focusing on just surviving, it now has to select a business model that can succeed in the decade to come.

Finding successful long-term business models is not something that Citi has been good at. Walter Wriston (CEO of Citibank from 1967- 1984) developed the bank’s widespread international franchise, but he also installed a super-competitive ethos for the bank that led it to great heights before stumbling badly in the 1980s from bad loans and write-offs.  His successor, John Reed (CEO 1984 -1999), led a technology revolution (ATMs, etc.) that installed Citi as the leader in retail banking, but also agreed to sell the bank to Travelers Corp. in a transaction that would establish the surviving enterprise as the world’s largest and most diversified financial conglomerate until that too fell apart.

Reed, who later admitted the merger was a terrible mistake, was eased out by Sandy Weill, Travelers head, who soon launched the aggressive integrated business platform that combined Citi’s lending activities and expertise with Salomon Brothers’ capital markets and trading skills. He also used further mergers to triple the assets of the conglomerate from $700 billion to a peak of $2.4 trillion, and extend its reach, complexity and risk exposures by more than that.

The effort turned out to be a painful lesson in corporate hubris. Citi was deeply tied in with Enron and WorldCom, the two poster children of the tech-wreck of 2000-2002, costing it many more billions in write-offs, fines and legal settlements than it had earned in all of its corporate finance activity since the merger.  Controversies abounded and ultimately Sandy Weill was removed as CEO after the NY Attorney General threatened to sue him and the bank for fraud in 2003.

Sandy was followed by two poorly chosen and ineffective CEOs who were unable to control the reckless, performance-driven juggernaut that Sandy’s ambitions unleashed. There were several further instances of unethical conduct, involving investigations by several foreign governments and a string of US legal encounters that led one federal judge to describe Citigroup as a “serial offender.”

The mortgage securities crisis in 2007-2008, however, proved the undoing of Citi’s voracious business model. It crashed and would have died in 2008, having written off more than 100% of its capital, but the government, fearing the bank was too big to fail, bailed it out – in a series of capital infusions and a lot of assistance from the Federal Reserve.

Since then, the present management team, in place since 2012, has devoted itself to cleaning up the mess. It sold assets, added new capital and did what it could to shore up the balances sheet and relations with its regulators. Total assets are now down to $1.8 trillion and headcount has been reduced from 357,000 at its peak, to 219,000.
But the tougher news is that Citigroup’s stock price, even after benefitting from the Trump rally, is still off 90% from its 2007 peak. And, for the past nine years, Citi’s EVA (return on equity less its cost of equity capital) has averaged -13%; though in 2016, it was only -5.13%. The bank’s price to book value ratio today is 0.80%.

The bank now has two core businesses: global consumer banking and global wholesale and investment banking. Roughly half of the bank’s revenues now come from consumer banking, about half of which comes from Asia, Mexico and other emerging markets.  The other half of the revenues is divided about equally between wholesale banking and securities transactions. Citi’s net income in 2016 was $14.3 billion vs. JPM’s $24.7 billion

In his recent shareholder letter, Citigroup CEO Michael Corbat announced that “our restructuring is over” and that he has a “deep conviction…” that Citi has “the right model, the right strategy, the right customers and clients, and the right people in the right places to meet our update targets.”

These targets include achieving a return on tangible equity of 10% in 2019 after utilizing deferred tax assets. This is a pretty low bar for judging success. (Citi’s ROTE in 2016 was 7.6%; JPM’s was 13%). Return on total equity would be about 2% less than the return on tangible equity.

Nevertheless, Citi’s cost of equity capital (using the Capital Assets Pricing Model) is presently about 12%, which means that even if it hit its target return two-years from now, it still would be earning less than its cost of equity capital more than 10 years after the financial crisis that brought it down.

Corbat is making three key assumptions that will determine the future of the bank.

One is that his choice of a global universal banking business model will pay off despite slow global growth rates and increasing costs and constraints of regulation and exposures to litigation. If the model can only generate a return on equity less than its cost, the long-term prospects can hardly be seen as viable.

Second is that the Citigroup team is capable of executing the business model effectively, despite its broad reach and complexity (e.g. trading operations in 80 countries). Citi has lost some market share in total capital market originations over the last decade, falling to 6th from 4th place. But now that its restructuring is over, will it attempt to catch up by re-adopting the hard-to-control aggressive business practices of the past.

And third, that investors will continue to tolerate low returns and lackluster stock prices (Citi has lagged both JPM and Bank of America over the last ten years, and in the rally since November despite the support of a $10 billion stock buyback program). If these don’t change – and the two-year targets suggest they wont - shareholders may demand yet another management change, one that finally would be willing to break the company up into two separate companies that could operate more entrepreneurially. 

From: eFinancial News, April 1,2017

Saturday, March 18, 2017

Can Trump Deliver on Growth?

 by Roy C. Smith

“This is the winter of our [economic] discontent, made glorious summer by this son of [New] York.” Shakespeare’s opening lines from Richard III, modestly paraphrased, seems to explain the appeal of Donald Trump to his supporters.

Economic discontent? The average US GDP growth rate for the fifty years from 1950-2000 was 3.5%. But, the average GDP growth in the US over the past 16 years is 2%. The slowdown has occurred despite massive efforts by the government to stimulate growth through debt-financed fiscal and monetary interventions.

There is a huge difference between compounding growth at 2.0% instead of 3.5%. It shows up in lackluster performance of investment assets that are essential to pensions and health insurance funds and the states, municipalities, corporations and unions that sponsor them; it has reduced demand for labor to an extent that middle class incomes have been stagnant for decades; and efforts to spend-out-of-the-slump have increased debt-to-GDP levels to record heights thereby weakening the financial standing and capacity of the country.

No wonder, we have discontented voters. As my barber said to me yesterday, “I am a ‘deplorable’ (using Hillary Clinton’s term for a Trump supporter}, because my economic condition for my stage of life really is deplorable.”

Expectations of improved growth under this son of New York are still high – as seen so far in a 10% rise in US stock prices, a boost in consumer confidence, and sufficient increase in recent economic activity (low unemployment and rising consumer prices) to cause the Federal Reserve to raise interest rates a couple of times by small amounts. That’s good, but the hard data haven’t been so encouraging - fourth quarter 2016 GDP growth declined to 1.9%, and first quarter 2017 growth is tracking at only around 1.5%. Janet Yellen said she was “optimistic” about recovery because the Fed’s forecast of growth for 2017 and 2018 was 2.1%, which was better than the 1.7% average for 2016 and 2017.

Better, but hardly enough.

We are now five months since the Trump election, and little that we have seen so far encourages a picture of growth above 3% within the next two years. 

So far there have been a lot of executive orders requiring reviews of existing government programs with the idea of reducing regulatory costs. But as Mr. Trump’s executive orders on immigration have revealed, these can and probably will be challenged in courts and therefore take considerable time to affect meaningful change. Meanwhile, the effort to restrict immigration runs contrary to growth - we need more immigrants to prevent the US labor force from shrinking, which would reduce GDP growth.

Health care reform has also got off to a slow start, the Congressional Budget Office said 24 million Americans would lose health insurance over the next few years, but the plan would reduce the federal costs by $3.4 billion or so per year. The net effect would be an increase hardship and withdrawal of subsidies from about 7% of the population, resulting in a modest drag on growth. In any event, the plan will have to be revised to get by the Senate, which will also take time and divert focus from economic recovery.

Last week Mr. Trump announced his budget plans, which mainly consist of a 10% increase in military spending paid for by across the board slashes in everything except health care entitlements and social security. It is hard to see how such a budget would add to growth, but it is also hard to see what the real budget may yet be because the plan submitted is also unlikely to be approved without considerable change.

Next on the announced Trump agenda is corporate tax reform that is largely unnecessary. Yes, the US has a very high statutory tax rate for corporations (35%), but the average rate actually paid (27%, because of various deductions) is about the same as the world average. The $2 trillion in funds held abroad to defer taxes can still be loaned to US subsidiaries so domestic investment is not curtailed.

The Trump plan, however, will lower corporate taxes for those paying more than the average rate, but is meant to be “revenue neutral.” That is, it will be paid for by a complicated $100 billion “border tax adjustment” on imports, contrary to G-20 and WTO rules. This would be a considerable expense to large retailers and their customers, and to companies with global supply-chains. It too will be a highly controversial plan when Congress gets to it, and will take a lot of time and political capital to push through. But, it is hard to see how it would help increase US GDP growth.

The also promised cuts in individual tax rates, and a massive infrastructure spending plan promised during the campaign probably will be put off until later and probably not go into effect until 2018 or 2019, if ever. These will also be controversial because it is not clear that they are needed to boost growth or that they can be funded without adding considerably to outstanding government debt.  The relatively low rate of unemployment (4.7%) suggests the stimulus effect may increase inflation more than growth, and with government debt at 105% of GDP (the highest level since World War Two) there is little capacity or Congressional willingness, to increase it further.  

By contrast, the stimulative tax cuts of the Reagan administration, enacted in 1981, occurred when the unemployment rate was 8.5% and the government debt to GDP ratio was 32%.

Changes to the Dodd-Frank Wall Street Reform Act, which promise to reduce regulation on banks and free up lending, have been lost in the delayed Congressional schedule. It will probably not come up until 2018, meaning that any impact on growth will be at least two years away.

Discontent with the economic conditions of the country led voters to select Republicans to run the show. The President, a quirky son of New York with no experience in government, has now encountered some of the considerable difficulties of actually doing so, and most of his intended economic initiatives are stalled or in need of revision.

The President has not yet demonstrated a clear agenda for executing a credible economic recovery plan. Such a plan is certainly needed, but whether we will get one or not is hard to tell. In any event, indications now are that it will not have any effect for 2 to 3 years and will fall short of what is necessary to return growth to the 3% area.

The stock market has not curtailed its enthusiasm for Mr. Trump’s expected economic recovery. A great deal of new money has been flowing into US stocks since the election on the promise of greater growth. When the reality of reduced expectations finally catches on, then a major market adjustment will be inevitable.

Richard III reigned for only two years, during which he confronted two rebellions. At the end of Shakespeare’s play, Richard III cries out “a horse, a horse, my kingdom for a horse,” as he is killed in battle after an uprising led by Henry VII in 1485. The horse was unavailable, it has been said, for want of a nail to attach a horseshoe - a metaphor for good governance -- and as a result, a kingdom was lost.

Monday, February 13, 2017

Trump’s Executive Order on Finance Might Just Work Out Best

By Roy C. Smith

Mr. Trump’s executive order on Dodd Frank and financial regulation announced on Feb. 3 doesn’t seem like much of a shake up – all it did really was ask for a study -  but it may turn out to be the easiest way to address his tough anti-bank campaign promises, yet still ease the way for the financial industry to finance growth.

As a candidate Mr. Trump pledged to “dismantle” Dodd Frank and “break up the banks. “ The Republican Party platform on which he was elected also called for reinstituting Glass Steagall, the 1933 law that separated banking from securities activities until it was repealed in 1999.  Since the election, attention also has been drawn to Congressman Jeb Hensarling’s proposed Financial CHOICE Act that would enable large banks to opt out of Dodd Frank under certain circumstances.  And, during his confirmation hearings Treasury Secretary nominee Steve Mnunchin said the government might adopt a “ringfencing” plan similar to the one the UK approved to minimize systemic risk.

It now looks like none of these are likely to happen, but instead a new Trumpian solution will emerge that will fix the problems posed by the both “reckless banks” and the “disastrous” legislation enacted by the Obama Administration.

Critics of the 2010 Dodd Frank Wall Street Reform Act agree that it is too big, cumbersome and costly and it has negatively impacted economic growth by limiting corporate access to credit. Its supporters claim it is a necessary effort to prevent future bailouts of banks and to reduce systemic risk and misconduct in financial services.

The structure of the Dodd Frank law is to require each of nine financial regulatory agencies (headed by presidential appointees) to adopt 390 new “rules” that implement the various provisions of the statue.  Only about 80% of these new rules have been adopted so far; it takes time to write them, wrestle with lobbyists and industry opinions and finally get them in place. But the teeth of the law are in these rules. Change the teeth and you change the law.

The Trump plan apparently was devised by Gary Cohn, ex Goldman Sachs COO and now Chairman of the National Economic Council. No one knows more about the costs and benefits of Dodd Frank than Cohn who has spent six years supervising its implementation at Goldman Sachs and adapting to its strategic constraints. No doubt Cohn has collaborated with Jay Clayton, a respected securities lawyer at Sullivan & Cromwell, and newly designated head of the SEC.

These men know that there are some good and useful parts to Dodd Frank that strengthen the financial system. They also know that the financial industry has spent in the area of $35 billion setting up systems to comply with Dodd Frank, and they don’t want to see the whole regulatory structure uprooted and replaced with something new that they would have to adjust to all over again. They would rather see existing rules changed to eliminated the unnecessary, ineffective and burdensome parts while preserving the basic framework they have become used to.

The Trump executive order requires the Treasury Secretary (who is chairman of the Dodd Frank created Financial Stability Oversight Council) to report back within 120 days as to which of the existing myriad outstanding financial regulations (not just those from Dodd Frank) support Mr. Trump’s new “Core Principles” for financial regulation, and which do not. These Core Principles include many of the regulatory objectives of Dodd Frank, but, unlike that law, they also require that the regulatory system not impair economic growth or weaken financial markets.  

Some of the offending parts of existing regulations can be fixed by having new appointees change the implementing rules. Other parts may require a legislative amendment to Dodd Frank, which, if technical or only involve obscure details, could be inserted into some other law likely to be passed with the Republican majority. The basic idea, however, is to fix what you can in a timely way, but avoid a big battle in Congress (that could take 60 votes in the Senate that Republicans don’t have) to repeal the old law and to replace it with something new.

Even so, a lot of work will be required in the next 120 days to identify the offending, non-Core parts of all existing financial regulation, and then a lot more work and time will be required to write up the rule changes and get them implemented.  The net result is probably that the smaller banks will be given some well-deserved relief on the applicability of the Dodd Frank to them, and the bigger ones will get relief on rules affecting trading, derivatives, compensation and consumer financial protection, and on some of the burdensome compliance and reporting requirements.

But the banks will still be subject to the tough capital requirements of Basel III, and to the qualitative stress tests applied by the Federal Reserve. The Trump plan will not be a return to the status quo ante 2008, but it should help the industry on the cost side and allow more lending to companies seeking credit.

Indeed, it might just be about right. 

Friday, February 10, 2017

Financial Reforms Will Favor US Banks

By Roy C. Smith

Stock markets have been especially kind to US and European banks since the Trump election, and last week’s announcement of an executive order to reduce financial regulation added a further boost. But, regulatory relief will be slow in coming and may not be as much as markets seem to expect. Still, the net effect should widen the competitiveness divide between the large US banks over Europeans.

The Trump approach to financial regulatory reform is as chaotic as everything else.  In the past year, he has said he wants to dismantle Dodd Frank, to break up the banks, and to restore Glass Stegall. He has also said he supported the Financial CHOICE Act, for which Congressional hearings will soon begin. But, on February 3rd he took a different (or an additional) approach by issuing an executive order to establish “core principles” of financial regulation, which include remaining tough on the banks, but eliminating ineffective regulation and that not vetted by rigorous cost-benefit analysis.

That’s been enough to get markets thinking that Dodd Frank will be defanged, new regulations (and litigation) will be halted, rules limiting proprietary trading and derivatives will be loosened, and the whole compliance process will be made less cumbersome, costly and time consuming.  For the first time in years, all but one of the six leading US capital market banks are trading above book value (Citigroup is still at 78% of book). One analyst recently predicted that these banks will have $100 billion more to distribute to shareholders through dividends or buy backs because of regulatory relief.

Others, experts in Congressional and regulatory procedure, say not to hold your breath.

The revived effort by Jeb Hensarling, chair of the House Financial Services Committee, to enact his Financial CHOICE Act that substantially amends Dodd Frank and provides an opt-out from it, will require 60 votes in the Senate that Republicans don’t have.

Further, Mr. Trump’s heralded executive order, which aims to reduce the burden of the 400 new rules that Dodd Frank required regulatory agencies to issue, is at least two years from any significant impact. Rule changes are bound by administrative procedure and are subject to public comment and legal challenge in the courts. In any case, it takes time to sift through all the Dodd Frank rules and all the others on the books, as the executive order requires, and to figure out what to do about them.

How much relief this might provide large banks is unclear. Most of the regulatory weight of financial reform since the 2008 crisis is concentrated in the much-tightened Basel III minimum capital requirements, which Mr. Trump will not abandon, and in the qualitative stress tests conducted by the still independent Federal Reserve. 

Still, most observers believe that the US regulatory burden will not increase, starting from now, and is likely to be reduced over time by the Trump government, though the amount of benefit this will produce may be less than the markets now assume.

But any relief is better than none, and will free up funds with which banks can compete for market share and for shareholder investment with their shrinking number of European rivals.

More important than regulatory relief to the banks, however, is the positive market sentiment that expectation of Trump economic policies has brought. Higher US growth rates, more capital investment, more mergers and larger project financings than would have occurred under a Hillary Clinton government, and certainly more than can be expected in an EU split by political divisions and still stuck in a low growth mode.

The three remaining European capital market banks (Barclays, Deutsche Bank and Credit Suisse) have benefitted from the Trump rally too, but still lag their American competitors. Credit Suisse now trades at 68% of book value, up from 44% in the summer; Barclays is at 58%, up from 34%, and Deutsche Bank, is only at 37% of book, up from a miserable 23% last September.

None of these banks can expect much from US regulatory easement, and instead, are stuck with adapting to a gloomy European political and economic outlook, Brexit, ringfencing, balance sheet and income statement problems, and continuing worries about US litigation for misselling mortgaged-backed securities, money laundering and sanction-breeching, which led to Deutsche Bank’s full page apology to shareholders last week for another massive loss.

American banks will likely assume that the improving economy and the expectation of regulatory relief that has driven up their stock prices removes the pressure on them for any sort of strategic realignment – that is, to separate themselves into two businesses, commercial banking and investment banking, rather than continue to try to operate both under one roof. It is doubtful that this strategy is correct, especially for Citigroup and Bank of America, but the sharp rise in their stock prices has kept this wolf from their doors, at least for now. 

European banks, on the other hand, continue under pressure from the market to split up or back away from capital market activity which has proven so difficult for them to master.  More positive developments from the US will widen the gap between US and European capital market banks. But the Europeans still in the game believe they have little choice but to remain in it. At least for now.

Published in eFinancial News, 2/10/2017

Wednesday, February 1, 2017

Where’s Trump Going on Consumer Financial Protection?

Ingo Walter

            Before and after enactment of the Dodd-Frank legislation in 2010, concerns were raised that consumers often lacked the knowledge to evaluate and make informed decisions about financial services.  Some of the most important involve home mortgages, car loans, asset management, retirement planning, household credit for major durable purchases and credit lines for ongoing household expenses, life and nonlife insurance to keep a family secure, and many more. In the past, the government and employers often made some of the most important financial decisions on behalf of households - for example by providing Social Security or defined-benefit employee retirement plans. Today, households are mostly on their own.

Not such a bad thing, with plenty of financial products and competitors from all kinds financial firms to choose from. But with time financial products have become more complex and less transparent, and a there is bewildering range of options being pitched. Often financial salespeople are under heavy pressure to cross-sell, leading to unneeded new accounts or up-sold services, sometimes attached to an array of embedded and sometimes undisclosed fees. Certain products, such as some kinds of variable annuities, can be almost impossible for consumers and even salespeople to value and identify the associated risks.

And it’s not too late to remember the mortgage “affordability” resets, embedded options and prepayment penalties offered to eager households back in the glory days of the mortgage boom a decade ago. The financial crisis soon placed many of these issues in sharp relief in the US housing market’s mortgage-origination “fee machine,” and through financial contagion its contribution to global systemic risk.

As in any market, there are buyers and sellers, and it’s in the interest of both to come to market fully informed about the price and the exact terms of what is being bought and sold. There are always mistakes being made, but the playing field should be as level as possible for the market to do it’s work – wealth creation, rather than wealth redistribution.

The argument for regulatory intervention is that consumers frequently suffer from market attributes that are stacked against them, so that caveat emptor is an inappropriate model for conduct in the marketplace. The basic sources of consumer disadvantage are found in lack of education and financial skills, lack of transparency in financial products and services, lack of fiduciary responsibility on the part of financial services vendors, and exploitation of vendor conflicts of interest.

Few would argue that consumers should escape the need for proper due diligence, or escape the consequences of their own errors. Moral hazard alone makes an excessively robust consumer safety net untenable. There should be plenty of holes in the safety net. But a systematically biased playing field that aggressively steers consumer choice, provides incomplete and biased information, and creates conditions of financial exploitation is no less toxic. It drains trust from the system. Without trust, neither financial efficiency nor stability can be assured – and ultimately encourages excessive regulation when the political costs get too high. So there is a legitimate argument that both remedial and preemptive improvements in some key dimensions of consumer finance are a good idea.

First, consumers need to be financially literate in order to make well-informed choices in complex financial decisions. There have been some severe gaps. Consumers often do not understand fundamental financial concepts such as compound interest, risk diversification, real versus nominal values, and even the difference between stocks and bonds. Indeed, the evidence suggests that consumers   with higher levels of financial literacy plan better for retirement, while those with lower levels of literacy borrow more, save less, and have more trouble repaying their debt, making ends meet, planning ahead, and making important financial choices.

But seriously, who’s going to cut down on time devoted to their jobs and recreational priorities to take Adult School classes in basic finance? And sometimes too much information is provided and leads to information overload, which can cause consumers to focus on only a few pieces of easily understood information, not necessarily the key aspects for complex financial decisions – relying instead on a few simplified explanations.

There are of course counter-examples. One is lapsed life insurance that can be surrendered with total loss of capital, sold back to the insurance carrier at a substantial discount, or sold to third parties for securitization and marketed to investors - sometimes called “death bonds” or “mortality bonds”.  Another example is long-term care insurance, which can be an expensive but rational choice for consumers, or a combination of life insurance and long term care insurance to lower the cost.  Consumers sometime seem to display remarkable clarity in thinking about the options, even though pricing and disclosure specifics may remain obscure.

Still, consumers can be overly optimistic in interpreting information in a way that that helps lead them to a desired if irrational conclusion. And there’s concern that some financial firms purposely design and proactively advertise products to mislead consumers about benefits, leaving “financial health warnings” to the fine print. Some classes of consumers - such as older people preoccupied with life’s other challenges, minorities and women - may be particularly vulnerable to aggressive marketing practices for financial products and leave consumers disproportionately on the receiving end of exploitation. And it’s been argued that complex financial products survive in the marketplace because they enable cross subsidizing sophisticated consumers at the expense of the unsuspecting. Regulatory intervention in that context will tend to redistribute income away from sophisticated customers, who prefer less consumer protection.

The underlying argument is that fairness embodies more than moral or ethical content in the financial architecture. Failure to provide equitable treatment undermines confidence in the system and impact liquidity, efficiency and growth. It distorts financial flows on the part of ultimate sources and uses of funds, and undermines the political legitimacy of financial intermediaries and those who regulate them. So sensible government intervention is needed as a matter of the public interest.

Dodd-Frank and the Consumer Financial Protection Bureau

This is the logic behind the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, which created   the Consumer Financial Protection Bureau (CFPB) as an independent unit within the Federal Reserve System. Dodd-Frank was mainly about financial stability and systemic risk. But “consumer protection” in the title signaled the its political centrality in setting out the future rules of engagement.

Dodd-Frank’s consumer protection legislation covers depository institutions with assets exceeding $10 billion, mortgage lenders, mortgage servicers, payday lenders and private education lenders. It does not cover automobile financing.

The legislation created the Consumer Finance Protection Board (CFPB) with a mandate to aid consumers in understanding and using relevant information and shielding them from abuse, deception, and fraud by ensuring that disclosures for financial products are easy to understand. It is also mandated to conduct consumer finance research and provide financial literacy education. It has the authority to set rules under existing consumer financial law and take appropriate enforcement action to address violations. It is charged with collecting, investigating, and responding to consumer complaints. And it has a mandate to ensure that suitable financial products and services are made available to consumer segments and communities that have traditionally been underserved.

The CFPB itself is an entity of the Federal Reserve System, and its budget is self-determined and funded out of Fed resources, not by Congressional appropriation – thereby offering some protection against inevitable lobbying pressure. It is managed by a Director (currently Richard Corday) who is appointed by the President   with the advice and consent of the Senate, serving a five-year term and who (like that Chair of the Federal Reserve Board) can be dismissed only “for cause.”

The Financial Choice Act

The consumer protection provisions of Dodd-Frank and the CFPB were controversial from the start, with criticism spanning a range of issues from the constitutionality of its mandate and the heavy hand of overregulation to the “blank check” funding through the Fed and the early cases demonstrating its allegedly excessive use of enforcement powers. Much of the criticism was concentrated in the draft Financial Choice Act (FCA) tabled by Republicans on the House Committee on Financial Services in June 2016..There are two major themes in this proposed CFPB revision:

The first is governance and accountability. As a unit of the Federal Reserve System, CFPB governance was considered both indirect and lacking a clear public mandate and political accountability. Moreover, its budget (close to $1 billion in fiscal 2016) is thought to escape the kinds of checks and balances that apply to other Federal agencies. The Financial Choice Act would broadly extend to the CFPB the kinds of governance, accountability and budgetary appropriations that apply to other federal agencies.

The second key issue is the matter of consumer choice and cost. The CFPB is thought to preempt free consumer choice, transferring to CFPB bureaucrats key decisions about which financial products will be available and to whom, what product information needs to be disclosed, and how they are marketed and priced. The argument is that the CFPB has reflected a retrograde turn away from the market economy towards increased paternalism of the state. It highlights presumptive cuts in access to financial services to the un-banked and under-banked, increases in the cost of financial services, violates consumer privacy, and harms small businesses that rely on consumer financial products.

That said, convincing evidence suggests that tough consumer protection measures can in fact work. Take for example the 2009 Credit Card Accountability and Responsibility and Disclosure (CARD) Act, which capped credit card penalty fees that card issuers were using to make up for lost revenues during the recession.

A careful study of the CARD Act’s impact found that the reduction in fee revenue from cancelled "over-limit" and late fees did not in fact lead to banks increasing credit card interest rates or significantly raising other fees in the period through 2015, nor did it reduce access to credit for US households. In combination, the Act reduced cut the cost of financial services to consumers by about $11.6bn annually.

The Financial Choice Act proposes a range of specific reforms that would fundamentally change the operations, governance, accountability and funding of the CFPB, although it does not propose to scrap it.

Where Should the Trump Administration Be Heading?

Where the Trump Administration will come down on consumer financial protection and the fate of the CFPB and the Financial Choice Act is uncertain. But at least the FCA offers a considered road-map for change, one which deserves to be debated. It seeks to pare away some of the Dodd-Frank provisions considered superfluous or counterproductive, and increase the accountability and budgeting process of the CFPB to align it to governance of other important federal agencies, while increasing accountability to elected officials.

It is hard to argue against political accountability and financial discipline. Still, in a system driven by heavy lobbying and financial contributions by those who stand to gain or lose from consumer protection measures, the survival and impact of Financial Choice Act proposals, if enacted, are difficult to gauge. It is a major, highly complex exercise in cost-benefit analysis – one in which both costs and benefits are often obscure and second-best solutions are often welcome. Inserted into the coming overheated, lobbyist-driven political debate, it is not hard to imagine that consumer interests will once again come at the end of the line.

Of course there is always the threat of over-regulation, but there is also value in helping consumers gain financial literacy, in improving our understanding of how consumer financial markets work, in helping people access and use relevant  information, and in protecting them from abuse, deception and fraud.

Fintech is the wild card in the game. Several dozen players ranging from start-ups and proof-of-concept players to established veterans seeking “unicorn” status by disrupting a retail financial services considered overdue for disruption. They range from marketplace lending to robo-advising, from financial aggregation to retail remittances, from e-brokerage to retirement planning. As these “direct-connect linkages take root, some of the key household disadvantages in finance could melt away – especially as new generations of consumers come on the market – and the case for consumer finance regulation may weaken.

On the other hand, the legacy players weren’t born yesterday, and a wide range of fintech initiatives have already been internalized by the established financial intermediaries – even the independent “disruptors” themselves have found it opportune to link-up with fintech upstarts in joint ventures and as attractive acquisition targets. The fintech dynamic has its own ways of tilting the playing field and generating new forms of conflicts of interest. Good new or bad news? Some of both, no doubt, and time will tell. What is certain is that consumer financial protection will be a moving target.

What’s also certain is that there will continue to be many “sticky fingers” in finance, amply reflected in the waves of wholesale and retail banking scandals since the financial crisis. If nobody’s watching the store, bad things happen. The recent Wells Fargo case involving consumer cross selling - a core strategy deeply ingrained in Wells Fargo’s history, culture and incentive systems - shows how easily a good institution and good people can overstep even the most basic trust and fiduciary constraints in dealing with “soft target” consumers.

Indeed, in a highly competitive financial services market, profit often lurks in the shadows. Retail finance is particularly vulnerable to questionable financial practices given its gaps in information and understanding. So it is surely in the public interest to focus on remedies for market imperfections and professional malfeasance as they appear, and if possible preempt them. It may not be the “best” and most efficient approach, but “second best” can also leave the world better off – as always, the devil is in the details.

Whether the Trump administration and the Congress ultimately chooses the “high road” to consumer financial protection remains to be seen.

Wednesday, January 18, 2017

The Real Trump Effect in 2017

by Roy C. Smith

Suddenly, after Donald Trump’s surprise election in November, a weak economic outlook looked rosy and investors thrust caution aside as visions of tax cuts, infrastructure spending and regulatory reform danced through their heads.Stock markets around the world (except for Mexico and China) soared as, even before being sworn in, Trump demonstrated that he would be a powerful global player.

Now, with the price-to-earnings ratio of the S&P 500 above 26 (vs. a long-term average of about 15), some think the year-end rally was too much. This remains to be seen, of course, but what might we expect from the real Trump in 2017?

His agenda, based on many campaign promises, is more ambitious than any of his recent predecessors. But his plans lack important details and his cabinet and advisors lack the skills necessary to push complex bills through Congress. And, having trailed Hillary Clinton by more than 2% in the popular vote, his mandate to run things his way may be far weaker than he thinks.
He will probably start off with a wide-ranging repeal of Executive Orders issued by Obama, which will be welcomed by the private sector. Not all of these will make much of a difference, but they will be appreciated for their signaling effect – less regulation and government interference in business. The costs of regulation in the US have grown steadily over the years and now, according to some estimates, represent a drag on growth of 1% to 2% per year.

Next, he will attempt to bring forward two broad legislative programs – one involving a debt-financed economic stimulus package involving many components, and the other, the ”repeal and replacement” of two key Obama programs in healthcare and financial service regulation.

The stimulus program was never described as such – instead it was sold as a necessary reaffirmation of American values involving tax cuts, and enhanced spending for public infrastructure and national defense, together with a naming and shaming effort to recover jobs lost to manufacturing abroad. This initiative, however, is not supported by offsetting cuts in public spending so it would significantly increase the federal budget deficit and the amount of government debt outstanding (already at 104% of GDP, the highest level since WWII).

However, the debt component of the Trump stimulus effort is likely to meet considerable opposition among conservative Republicans. So, for this legislative effort to succeed there will have to be significant downsizing and compromise, and this could drag things out several months. Nevertheless, it is likely that some of the Trump stimulus plan will survive. How much it will boost growth and job creation in a still sluggish but recovering economy now operating at full employment is very uncertain, but it is likely to be modest in 2017.

The second legislative effort will be to “repeal and replace” Obamacare (the Affordable Care Act that provides health insurance for those otherwise uninsured), and the Dodd Frank Wall Street Reform Act, both of which narrowly passed with no support from Republican members of Congress. Trump has the votes to repeal these landmark legislative achievements of the Obama administration, but as yet no clear plans for their replacement.

Both issues are controversial and are unlikely to be settled quickly or without a lot of confusion as to what will happen next. The healthcare industry represents about 16% of US GDP, and banking another 10%. Health care could actually contract because of the uncertainty as to what will replace it and when. Republicans in the House of Representatives have a plan for replacing Dodd-Frank that many large banks will appreciate, but these banks are still required to comply with Basel III and its latest additions to capital “cushions” and similar requirements. Despite some considerable relief in the Trump stock market for healthcare and banking stocks, 2017 doesn’t look like a year of substantial profit improvement for either industry.

Finally, Trump will have to decide exactly what he wants to do to change trade relations with China and Mexico. His “America First” theme to recover manufacturing jobs lost to these countries either because of unfair trading practices or badly negotiated trade agreements (Nafta) has had a lot of popular support, but reflects little appreciation of legal and economic realities. He has threatened to raise tariffs significantly on imports from both countries, which some fear could start a trade war.
He can easily make a case that Chinese government subsidies of exporters and its non-tariff barriers to US exports and foreign direct investment, and the occasional case of dumping, have distorted trade relations to the point where corrections are necessary. President Nixon took such a position in the early 1970s when he raised tariffs suddenly on Japanese imports, gaining concessions as a result.
Trade of course is a very thorny issue, with US manufacturers’ supply chains and major agricultural exporters right in the middle of it. Mexico’s case is arguably more complex and less urgent, and Mexico has noted before that as its growth rate declines, illegal immigration to the US increases, wall or no wall.

Here we must rely on Trump’s long history of deal-making. He announces big objectives, threatens and blusters to get the attention of the other side, then finds a workable compromise that he can describe as a success. As with his Twitter-fed negotiations with Carrier, Ford and some other large US companies, a few moderate concessions can be enough for a victory celebration.

Deal-makers are not ideological; they just need to show that they can pull off big, unexpected transactions, often by conceding a lot themselves.

The good news for those scanning prospects for 2017 is that the Trump effect most likely will be less disruptive than many have feared, but will still be a net positive contributor to US economic growth, especially as compared to a Clinton presidency.

The bad news, however, may be that Trump’s bold, blustery, and populist approach to politics and economics will be seen as successful enough in Europe to encourage imitation in the several important political contests scheduled for 2017. There, however, even modest shifts towards nationalism could significantly impair the ability of the EU and the Eurozone to cope with increasing pressures that are developing to dissolve them.

Thus, an unexpected irony of Trump’s election, may be that it could have more effect in Europe in 2017 than in the US.