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Dumping Dodd-Frank Could Restore Executive Accountability

"After all, who ever washes a rental car?"

A variation of this expression has been used many times over the years by public officials and commentators. This specific line was from Warren Buffett's 2004 annual letter to shareholders. (The annual letter usually contains such a gem or two.) It has particular relevance to today's discussion about rethinking the financial regulatory structure.

With the election of Donald Trump, an inflection point and opportunity have arrived. The leadership transition due to take place in January includes expectation of regulations being repealed, including the promise to dump much of the Dodd-Frank Act. Many in Congress have already been pushing to cut back Dodd-Frank, including House Speaker Paul Ryan, who is on record supporting the repeal of certain provisions in the law.

Absent from the debate over rolling back Dodd-Frank is recognition of how a regulatory recalibration – restoring balance between risk and rules – would also restore more personal responsibility on the part of financiers.

The "rental car" in the oft-used expression could be a metaphor for the current financial services industry. It has been so influenced by government regulation since the crisis that executives and boards of directors perhaps feel less ownership and accountability for its performance. Good governance recognizes that executives should treat the bank's investments at least as carefully as their own money – or car.

In his 2004 letter, Buffett was referring to the importance of aligning executive and director incentives with shareholder interests. He wrote to shareholders, "All [Berkshire Hathaway] directors purchased their holdings in the market just as you did. We've never passed out options or restricted shares." He went on, "The downside for Berkshire's directors is actually worse than yours because we carry no Directors & Officers liability insurance."

Buffett's approach here is simple but far-reaching. Directors and officers put "skin in the game" and hold the same economic upside and downside as shareholders. They also face personal liability and full accountability for the legal ramifications of any misdeeds. Directors and officers do the right thing in part because it is in their personal interest to do so.

This equation is more complicated for banks. In addition to shareholders, depositors count as key stakeholders and by extension so does their insurer, the FDIC. Yet the interests of depositors and shareholders can be at odds: greater risk-taking may yield higher profits but may also imperil deposits (and even the banking system itself, as we saw in the financial crisis). There is a built-in tension. So something more is needed. But what?

In reaction to the financial crisis, Dodd-Frank produced a blizzard of regulations to proscribe a litany of behaviors. But this approach has proven costly, complicated, stifling to innovation and susceptible to gaming. Worse, it may have actually undermined executive accountability: The CEO in effect becomes a compliance manager rather than driver of key business decisions, often left to rely on the secondary assurances from risk managers and other mid-level managers.

In short, massive regulation offers the opposite of Buffett's approach. By creating a system of highly detailed regulations that no CEO or board could recite, let alone master, Dodd-Frank and other regulatory schemes empower specialists, lawyers and bureaucrats.

Free-market conservatives naturally have the impulse to scrap the whole law. But the tension between insured depositors and shareholders would remain, with the potential for miscalculation, mischief and contagion. The stability of the American banking system, in fact, depends in great measure on the actual and perceived stability of insured deposits and on uniform standards of safe and sound banking.

So what new regime could replace Dodd-Frank to achieve true accountability, as well as promote appropriate risk-taking and innovation without undermining the safety and soundness of the world's most stable and important banking system?

For starters, any simplification of Dodd-Frank and related policies must be guided by three basic principles:

  • The risk-return ratio for depository institutions—banks—is and must remain different than that of more speculative businesses.
  • The capital-to-risk level must be mandated, transparent and enforced. (By at least one estimate, the largest banks in the world ascribe zero risk to 55% of their assets, an obvious understatement of actual risk).
  • Executives' personal risk and benefit must align with the long-term success of the enterprise. This basic principle means that illiquid ownership, rather than stock options, provides a better incentive approach. In addition, clawback provisions and other components of compensation should be considered a basic staple of bank executive compensation. And it means that the risk for bank failures include real penalties, fines and personal liability for negligent executives and wayward bankers.

Greater personal accountability is never popular among those who hold authority. But common sense and history show that it is essential.

Revisions to our banking regulations must be informed and tailored to the unique role of banks so that we don't make a challenging situation worse. But such revisions should also focus on financiers taking greater ownership for their actions. And if, in exchange, the industry is relieved of some of Dodd-Frank's overbearing and exceedingly complex regulations, a stronger culture of accountability might even be welcomed.

Patrick J. Richard is a partner with Nossaman LLP in San Francisco.

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Nice job of describing the perverse nature of excessive regulation. Over-protection undermines attention, personal responsibility and accountability.
Posted by MrPotter | Friday, December 02 2016 at 9:51AM ET
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