THREE STEPS TO A SAFER FINANCIAL SYSTEM / THE FINANCIAL TIMES COMMENTARY & ANALISIS ( HIGHLY RECOMMENDED READING )

Three steps to a safer financial system

By Philip Purcell

Published: December 14 2009 20:30

Americans have grudgingly supported the use of their taxes to save the financial system and economy. Unfortunately, this required rescuing many companies considered “too big to fail” that individually did not deserve to be saved. Taxpayers resent their money being used to keep these companies out of bankruptcy and, in some cases, protect the multi-million dollar compensation packages of those who caused the crisis. In short, Americans understand the need to protect the financial system, but do not want the events of a year ago to happen again.

So one would think that we would be putting in place changes to prevent future catastrophes or at least substantially reduce the cost to taxpayers. But to date, there have been only short-term, stop-gap measures.

There are three areas where action could be taken right now: new capital requirements, profit-based compensation and greater board control over risk management and pay.

First, equity capital must be increased. This year, regulators shut down more than 100 banks that were undercapitalised. Smaller banks are now required to have 8 per cent tangible equity per dollar of assets (the leverage ratio). This stronger capital structure will reduce bank failures.

Too-big-to-fail institutions, however, should have a higher ratio of 10 to 12 per cent. This would not put them at a disadvantage; it would even the playing field. These institutions have an implicit, or explicit, federal guarantee on their debt that lowers their cost of capital, giving them a permanent competitive advantage. The public bears the cost of too big to fail. Since capital is the public’s main protection, it should be high.

The 12 per cent tangible equity requirement should apply to all financial institutions that have the implied federal guarantee, whether they are banks, brokers, insurance companies or government-sponsored entities. Any institution that does not want to be too big to fail can shrink through spin-offs and be eligible for the lower leverage ratio.

Second, regulators and boards should put in place compensation policies that strengthen capital and discourage reckless risk-taking. The recent efforts of President Barack Obama’s pay tsar, Kenneth Feinberg, have provoked a fair amount of consternation. One problem is the lack of any standard. How do you decide if a given amount of pay is too much?

Regulators are not in a position to decide on individual compensation. That is the job of management and the board. But regulators should look at overall compensation as part of their responsibility to make sure an institution is financially sound.

The best way is to focus on total dollars of compensation relative to total pre-compensation profits. The former should never exceed the latter; to do this amounts to looting the company’s capital and, as recent experience shows, endangering its existence. As a general rule compensation should not exceed 75 per cent of pre-compensation profits without prior approval of both the board and the regulator. This would ensure 25 per cent of pre-compensation profit goes to strengthen capital, reward shareholders and pay taxes.

Few would argue with regulating excess total compensation in order to keep institutions financially strong. Too big to fail does not mean big enough to pay competitive compensation despite poor performance. This also implies that the regulators will not need to look at individual compensation. Their focus should be on the health of the institution.

Third, boards must take responsibility for viewing compensation in the context of risk management. As a first step, compensation committees and risk-management committees should be merged. With knowledge of the risk-management processes and long-tailed risks at their institution, boards would be in a stronger position to weigh in on compensation.

In addition to the rule that total compensation can never exceed pre-compensation profits, boards should also consider that individual compensation above $500,000 be delivered in restricted common stock, and, second, that the receipt of common stock be restricted for three to five years, and then only delivered if the institution remains profitable.

All of these steps could be taken quickly . Not to do so will leave our financial system with an unacceptable level of risk.

The writer is president of Continental Investors and former chairman and chief executive of Morgan Stanley

Copyright The Financial Times Limited 2009