In addition to Ira M. Millstein’s active law practice at Weil Gotshal & Manges LLP, the widely acknowledged dean of corporate governance has taught for years at both Yale and Columbia. He does so in part to keep up with the changing attitudes of younger generations whose insights he frequently finds are different than his own. In preparation for a recent talk before a group of international financial executives, Millstein says he found his views becoming “radicalized” by his exposure to some of the questions his students are asking. Wary that the regulatory agencies now charged with implementing Dodd-Frank have both the resources and wherewithal to be effective against the systemic risks posed by big banks, NACD Directorship asked Millstein to share some of his current thinking.
Ira M. Millstein
What are your impressions of your students’ reactions to the financial crisis?
My students are incredulous. Until two years ago, if you asked my class at the Yale School of Management how many were planning to work in the financial sector, almost all the hands would go up. Today, maybe 30 percent. It has changed their vision of the world. What I have heard in virtually every class since the crisis is, “How could this happen and no one gets blamed?” They ask, “Where were the board, auditors, rating agencies and regulators? Where was everybody else who was in the game?
“Why,” they ask, “is no one penalized?”
Who was most responsible for the financial crisis?
Each of us has reasons why our respective sector is not at fault, and is ready with a standard response for why boards didn’t do anything “bad” and why professionals did not call it as fast as they should have, instead of going along for the ride. Maybe we did see things, but we did not become overly concerned about it because we were all doing “well.” Looking back, I think that everyone in this bubble was complicit. There’s an important story yet to be written as to what came over all of us.
How do you describe “the new normal?”
Briefly, a still-struggling economy, a regime of federally mandated corporate governance and a shift in the balance of corporate power in favor of owners. On the macro side, there is high unemployment, with little chance of change anytime soon, and slow consumer growth. Closer to home, in the boardroom, Dodd-Frank is an attempted overhaul of the entire United States financial system to mitigate systemic risk and, among numerous other things, afford shareholders new powers. Due to these and other corporate governance reforms, the balance of power has shifted to shareholders. It is yet to be seen if shareholders can or will use their new rights constructively.
What are the consequences of Dodd-Frank?
Dodd-Frank is a broad-scale effort to create “financial stability” by dealing with several potential causes of systemic risk. Currently, there are nearly 400 explicit regulations that must be written within the first 18 to 24 months after enactment by over 11 separate regulatory agencies, in addition to over 60 one-time reports and studies. Those related to systemic risk are to be coordinated by the Financial Stability Oversight Council (FSOC). How will this get done? Can the SEC do its job within 24 months? One of the causes of the crisis was regulatory neglect caused in part by a shift in macroeconomic theories and draconian cuts in the regulators’ budgets. Yet today there are calls to further defund regulatory agencies based on the same thinking that got us here.
Moreover, FSOC, which is supposed to be the overall stability board overseeing everything, is primarily composed of regulators who didn’t get it right the first time. And it will be difficult, if not impossible, for FSOC to force other regulatory agencies to coordinate and get it right. Therefore, I am wary about Dodd-Frank.
You have stated that executive compensation “is out of control.”
We need to change our way of thinking about compensation. Instead of tying executive compensation to the company’s stock performance, we need to align compensation to the company’s long-term performance and those internal drivers unique to the company’s sustainability. This would encourage boards to shift their focus from short-term results at the expense of long-term sustainability, including research and development. International bodies are at work on this issue, but I believe only boards can ultimately get compensation properly aligned with performance.
Has the consolidation in the banking sector created more companies that are “too big to fail”?
Both Democrats and Republicans have publicly said so. The six largest bank holding companies in the United States had asset values of 64 percent of the U.S. gross domestic product (GDP) at the end of the third quarter in 2010. In 1995, it was 17 percent of the GDP. The response of the government to the financial crisis, including TARP, had the effect of consolidating banks and thereby creating companies that are, as many say, still “too big to fail.” The rating agencies seem to agree.
Is this an antitrust issue?
Justice Louis Brandeis said it when he wrote Other People’s Money and How the Bankers Use It in 1914. Justice Brandeis worried about the thengrowing power of big banks, and advocated against bank consolidation. Of course we want an efficient, competitive banking sector, but we need to remember a time when the country was concerned with size, when Glass-Steagall dealt with the power of banks, without sacrificing efficiency. Our banking institutions and investment banks thrived quite well without becoming so large and diverse. Dodd-Frank is unlikely to be used by regulators to implement structural reform, but that may be considered should other means of dealing with systemic risk not work, assuming there’s a political will to do something else.
Can you describe the little-known part of Dodd- Frank referred to as the “living will” and its implications?
Section 165(d) of Dodd-Frank requires systemically important financial institutions to submit an annual resolution plan (aka “living will”). The annual living will must provide a road map for the rapid and orderly resolution of a company in a manner that avoids causing systemic risk. If regulators deem that the road map is not credible, then they are empowered ultimately to force divestiture and asset sales so as to avoid contagion. The banks now must report to regulators their ownership structure, assets, liabilities, contractual obligations, core business lines, critical operations, material entities, major counter parties, hedging and other derivatives transactions, international operations and corporate governance. Because of the potential consequences, boards of directors should be monitoring closely and proactively to protect their shareholders.
Has the dynamic changed between shareholders and CEOs?
With shareholders now having a more powerful voice, the dynamic is changing. CEOs and boards must be more cognizant of shareholder needs and work with them to cultivate relationships. Communication is critical.
I am a conservative who supported deregulation of the banking industry. Now I think deregulation was a huge mistake and the Glass-Steagall Act should be restored and hedge funds should be more regulated or even banned. Glass-Steagall prevented banks from owning securities firms and expanding to multiple states. While I once thought this law was anti-business and outdated, I now realize regulation is necessary to keep the banking industry safe by keeping banks from growing too big. Glass-Steagall is a proven law that protected the American financial industry well for 70 years and needs to be brought back immediately.
The financial crisis of 2008 and the current economic problems are partly due to the repeal of Glass-Steagall and the failure to regulate hedge funds. I am certain the world economy cannot risk another meltdown now. There is simply not enough money to bail out governments and banks of the world again.
The Dodd-Frank Act was enacted as replacement for Glass-Stegall, but I believe this new law is weak and doesn’t go far enough to prevent banks from owning investment companies, controlling banks from growing too big, and regulating derivatives enough. Bank of America, a bank, now owns Merrill Lynch, a brokerage firm, for example. Merrill Lynch recently moved $75 trillion of derivatives to the FDIC insured Bank of America side. If these derivatives
fail, Bank of America will be affected, and how will the US government bail them out? The
derivatives market is $600 trillion, but the economy of the ENTIRE world is only $74 trillion.
http://www.bloomberg.com/news/2011-10-18/bofa-said-to-split-regulators-over-moving-merrill-derivatives-to-bank-unit.html
http://articles.boston.com/2010-03-12/business/29329389_1_derivatives-gary-gensler-regulator
https://www.cia.gov/library/publications/the-world-factbook/geos/countrytemplate_xx.html
Billionaire Warren Buffet called derivatives “weapons of mass destruction” and Newt Gingrich thinks repealing Glass-Steagall was a big mistake.
http://www.economist.com/node/12274112
http://news.yahoo.com/newts-15-seconds-sun-094500280.html
Normally I am an optimist who doesn’t go around saying the sky is falling like a paranoid Chicken Little, but from my reading from trusted mainstream sources I have become quite worried about the economy. If I understood the risks of derivatives and debt in 2007 and said something, no one would have believed me. Now I hope people will listen when experts say the government needs to better regulate the financial industry.
Businesses and banks may say that regulation slows the economy, but I think that if the Glass-Steagall Act is not restored and hedge funds are not more closely regulated, there will soon be no economy at all. While I realize restoring Glass-Steagall and regulating derivatives is complex and difficult, I believe making a law is easier than repealing one.
I suggest reading “The Big Short” by Michael Lewis for a readable introduction to the financial crisis and why the banking industry needs to be regulated.
Restoring Glass-Steagall and regulating derivatives is a urgent problem and is not a issue that can wait to be fixed. I cannot stress this enough. Write to your elected officials, talk with your friends, and contact the media urging the government to make Glass-Steagall a law again and ask legislators to better regulate hedge funds.
“Too big to fail” is simply too big.