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A former banker says, “Maybe.”

A former regulator says, “Maybe not.”

It’s been a rough year for the finance industry—a year in which we’ve seen the decline of the housing market, the credit crisis, and the collapse of the auction rate market. Tens of thousands of finance industry jobs have been lost. The stock market has been rocketing up and down while consumer confidence has plummeted as quickly as the value of your 401(k) retirement plan or state-sponsored pension fund. Eager to apportion blame, pundits and politicians have been pointing fingers at everyone from deadbeat homeowners to Wall Street fat cats, from Republicans who deregulated to encourage free-market innovation to Democrats who encouraged risky borrowing to promote home ownership. It will take years of careful scholarship to fully unravel the many strands that led to worldwide financial turmoil.

But there is one thing everyone agrees on: some kind of regulatory change is needed.

Even a long-time regulator and a long-time banker can see eye-to-eye on that. Terry Iannaconi, MBA ’78, spent many years with the Securities and Exchange Commission and eventually became the Deputy Chief of Accounting in the Division of Corporate Finance; she is now a partner with KPMG, one of the Big Four accounting firms. Bill Longbrake, PhD ’76, spent many years in the financial industry and eventually became the vice-chair of Washington Mutual Bank—once the sixth-largest bank in the United States, now a victim of the financial upheavals of fall 2008. He now consults with the Financial Services Roundtable, a research and advocacy group for the finance industry.

Both Iannaconi and Longbrake have unique insider viewpoints on the finance industry. Do they think regulation can prevent future financial catastrophes?

Maybe, says the banker. “The current financial crisis is not a coincidence of bad decisions,” says Longbrake. “There are policy decisions and ways of doing business that have been in place for literally decades that have led to this crisis. There are long-term policy imbalances that have built up in the global economy which need to be corrected.”

Maybe not, says the regulator. “Regulation is inevitable and it will address some of the problems we’ve been going through, but it won’t address the main problem of human nature,” says Iannaconi. “I’m a free market theorist. I think that markets should be able to find their own demand and prices without government intervention. People should be able to make their own rational choices.” Unfortunately, Iannaconi adds, those choices aren’t always good for the economy. “I don’t think we can afford to be free market theorists any longer.”

Patching Up the Regulatory Agencies

Holes in the regulatory structure need to be addressed. Iannaconi says that as the government begins to think about regulatory reform, it may reopen the question of why we have multiple banking regulators. The Federal Reserve, Office of the Comptroller, Office of Thrift Supervision, and Federal Deposit Insurance Corporation all regulate pieces of the depository financial institutions.

Big institutions that provide a variety of financial services are particularly difficult for the government to monitor because they fall under so many different agencies’ jurisdictions. The SEC oversees the brokerage arm of a company. Bank regulators supervise its banking operation. State insurance commissioners supervise the insurance business. But no one agency is responsible for overseeing the operations of the institution as a whole. Oversight issues are certain to be addressed when regulatory reform is considered.

“At least with respect to company and function, the challenge is to design a regulatory framework that can operate on a highly sophisticated technical level for functions and products but also can step back and view the aggregate risks in the entire company,” says Longbrake. “This is particularly important in the case of highly diversified, large financial services companies.”

Rulemaking v. Macro-Regulation

Regulation also has a hard time keeping up with the rapid pace of change in the financial industry, often the result of technological advances. Today’s enormous computing power, for example, allowed the creation of intricate, extremely complex, hugely innovative financial instruments such as collateralized debt obligations (CDOs) and credit default swaps, which act as a kind of insurance to protect the holder of a mortgage security against a possible default.

Such instruments are getting a lot of flak these days, but they did what they were intended to do, says Longbrake: they spread risk out to many parties, not just in the United States but throughout the world, thus bringing down the cost of credit for everyone. But this also increased systemic risk in the global economy. In the short term, credit default swaps worked—which is why so many companies used them. Sophisticated models gave business leaders the ability to assess risk to their organizations in the short-term, but most did not recognize the systemic risk they were creating.

The federal government needs to be looking out for the economy as a whole, says Longbrake, who would like to see more government oversight of systemic risk, not just individual transactional activities. Longbrake is also concerned that the collective risk to the economy not being adequately assessed or monitored. He imagines a system that is based on overarching principles developed and overseen by a broad regulatory working group. “As times change, as markets change, as innovations come along, there should be a body within government asking the global questions, reporting to Congress, doing research and helping regulatory agencies make changes that can mitigate crises before they happen,” says Longbrake.

Iannaconni agrees: “The concern I had as a regulator, and have now, is that agencies may be well-meaning in their purpose and actions, but may drill down to the fine points of regulatory compliance yet fail to address the major macro-economic risks that are within the jurisdiction of the agency.” But she says that this responsibility seems to fall within the purview of Treasury or the Federal Reserve.

She agrees that a narrow focus on rule-making may come at the expense of a true broad understanding of the economic impacts of policy. Part of the problem, she feels, is that people in general are not receptive to government involvement in business when times are good. “We had an over-leveraged economy, but if the Treasury or Federal Reserve had tried to step in and dictate to banks how they should engage in private transactions—I don’t think that would have been tolerated,” says Iannaconi. “Today the culture has changed; now it might be accepted.”

Taking the Long View

It’s also time for a paradigm shift on the part of CEOs and corporate executives, say both Longbrake and Iannaconi. People naturally want to maximize their returns. That’s not a bad thing. But while maximizing outcomes is a reasonable goal, Longbrake argues that business leaders should start considering the time-frame over which this should take place. Focusing solely on next quarter’s returns is too short-sighted, he feels, and may even be detrimental to the company over the long term.

Iannaconi agrees. From a strictly legal perspective, the corporation is owned by shareholders, who elect directors, who appoint management. If shareholders want an optimum financial return, then managers have a fiduciary responsibility to work toward providing that optimum financial return. And yet managers might think about their fiduciary responsibility differently if they started taking a longer view.

“What we are dealing with now is a very long history of short-term financial optimization. In the end, no matter how many quarters of growth these companies have experienced, they lost at least five years worth of it in just 60 days last fall,” says Iannaconi. “In the long run, financial optimization needs to look at activities differently than short-run maximization. Short-run maximization may lead to long-run losses. Management needs to have a broader perspective, a longer-run perspective. That will ultimately be more of a maximizer than focusing solely on short-term concerns.”

“It’s difficult to make sensible judgments when your shareholders are focused on short-term profit,” says Longbrake. “Even the most thoughtful CEO who is a good communicator may have a hard time bringing investors along. But doing so is an important element of leadership.”

Getting the Best Information to Policy-Makers

Sometimes policy meant to improve the health of the economy does as much harm as good. Last fall, for example, the Treasury guaranteed bank debt in an attempt to unfreeze credit. Unfortunately, this drove up mortgage rates, which was not at all what policy-makers intended.

But this is the problem, says Longbrake, with creating policy on the fly in a time of crisis. Thinly-staffed government agencies simply don’t have the manpower to conduct studies on the efficacy of a policy at the moment when government intervention is desperately needed. But universities do. And business school faculty are well-equipped to do what government agencies are not: think about the impact and effects of policies before they are actually needed. In fact, the Smith School’s new Center for Financial Policy and Corporate Governance will bring together Smith School faculty experts as well as those from industry and government, providing a nexus to aggregate and synthesize the best of thought leadership for policy makers. Smith is uniquely positioned to provide these insights because its faculty is well-connected in Washington, and their intellectual capital spans a variety of different areas.

In the end, Iannaconni and Longbrake generally agree on how to fix what ails the finance industry: better oversight, a clearer blueprint to guide macro-oversight and regulation, and a longer-term viewpoint on the part of executives and investors alike. And if the former banker and the former regulator can come to agreement, perhaps policy-makers should take notes.

Smith Faculty on the Finance Crisis

Smith School faculty have been actively involved in advising key players and proposing potential solutions to the finance crisis. Albert “Pete” Kyle, Smith Chair Professor of Finance, worked as an expert for the SEC in conjunction with the OIG report on the collapse of Bear Stearns, briefing congressional staffers for Henry Waxman’s Committee on Government Oversight. Kyle and Haluk Unal, professor of finance, held a briefing session for members of the Senate and House Committees on Banking, reporters from Business Week, Dow Jones and U.S. News & World Report, and Department of Justice officials, at the Smith School’s downtown Washington, D.C., campus in the Reagan Building. Lemma Senbet, William E. Mayer Chair Professor of Finance, and N.R. Prabhala, associate professor of finance, were invited by Maryland Congressman John Sarbanes to brief his chief of staff and the legislative staff of the federal Oversight and Government Reform Committee on issues relating to the execution of the Paulson economic rescue plan. They and many other Smith finance faculty have provided expert commentary to numerous press outlets and news programs, including ABC, CNN, the Washington Post, Forbes magazine, Bloomberg, and NPR.

Here’s a sampling of their expert opinions: 

Lemma Senbet, William E. Mayer Chair Professor of Finance

We need to be sure compensation design is providing executives with incentives to perform, as opposed to incentives to manipulate performance. Research and development has a long-term influence on a company, but it does not have a short-term affect on profits, so there may be an incentive to delay R&D in favor of short-term profit…that is why we need to look at how compensation is structured.

Albert “Pete” Kyle, Smith Chair Professor of Finance

The trend recently, before the last year or so, has been toward deregulation. What you’re going to see in the next two or three years is that the government will be extremely, heavily involved in the financial markets. Fannie Mae and Freddie Mac will continue to be big problems and government will have stakes in banks it will need to decide what to do with. After two or three years of active involvement, I can see the focus shifting toward how to get government regulation into balance.

N. R. Prabhala, Associate Professor of Finance

This crisis is not entirely about credit or liquidity, but about consumer confidence in the residential home market. Some kind of direct relief to homeowners, or to buyers of homes, such as a tax break or perhaps direct subsidies of closing costs, might stimulate interest in buying homes. Of course that assumes that home prices are depressed below their actual value.