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Wall Street Gets Close to Stiffing Overhaul: Roger Lowenstein

Backroom trading in Congress has put meaningful financial overhaul in jeopardy at the 11th hour.

In two key aspects of the legislation, the Senate has refused to go along with the House version, undermining leverage limits on big, risky financial firms in the first instance and driving a knife through shareholder democracy in the second.

One clause in the House bill would be singularly effective in preventing a repeat of the 2008 banking collapse. The other would close a 75-year-old loophole in American corporate governance, forcing boardrooms to, finally, become accountable to shareholders.

Now, both are at risk. Take leverage limits first. Leverage acts like a giant accelerator in the financial system. It heightens the risk of financial crashes, and it magnifies losses when crashes do occur. No wonder that in 2008, as in almost every previous meltdown, excessive financial leverage played a big part.

The House bill sets a hard limit of 15-to-1 for systemically important firms. That is, big banks and other large financial entities could never borrow more than 15 times their equity. Regulators, including the Federal Reserve, could enforce even tighter limits, if they chose to, but they could never allow firms to borrow more than that.

Bankers don’t like the idea of a hard and fast limit, and neither do regulators at the Fed and Treasury, including Tim Geithner, the Treasury Secretary. Not surprisingly, officials would rather have the flexibility to set limits on a case-by- case basis than be handcuffed by a hard cap.

Sounds Nice

Flexibility sounds nice in theory but in practice it hasn’t worked. When the economy is roaring (as one day, it will be again) banks are flush with profits and eager to make loans. Bankers then insist there is little to fear, after all, they know how to manage their risks.

Memories of past crises grow dim. Moreover, the bankers will say, their clients are hungry for mortgages, leveraged corporate loans and other forms of credit. Why put a brake on the American economy? And regulators will go along. They did last time.

David Moss, the Harvard Business School professor who conceived of the cap, has argued that merely empowering regulators isn’t enough. Barney Frank, the House Financial Services Committee chairman, gets this. Frank is determined to fight for a 15-to-1 cap.

The Senate bill is in flux, but it is leaning toward a more lenient 25-to-1 standard. That wide-open sieve wouldn’t have stopped Citigroup Inc. on its path to overleveraging and self- destruction in 2008. Indeed, during the previous economic cycle, regulators at the New York Fed (then run by Geithner) were aware of Citi’s mounting risks, but didn’t move fast enough.

Hang Tough

Frank should hang tough. We need tough rules for regulators as well as for bankers.

Now shareholder democracy. This issue predates the financial crisis; in fact it harkens to the scandals of the 1920s. The problem is that shareholders have no effective way to hold directors accountable. Proxy contests are all but rigged, because incumbent directors use corporate funds to solicit votes; dissidents must spend their own dough.

Typically, incumbents capture 99 percent of the votes. Not even Hugo Chavez polls that high, and it is no wonder that boards are so apt to ignore shareholder concerns. Since the 1990s, reformers have realized that the key to genuine democracy is to grant legitimate non-management candidates access to the company ballot (the proxy card that the board distributes and that all shareholders pay for).

Too Much Democracy

The question is how to define “legitimate.” The Securities and Exchange Commission has proposed a rule that would allow nominations from minority shareholders that owned a reasonable minimum of shares. Of course, nominees would still have to win elections to join the board.

Even that dollop of democracy is too much for the Business Roundtable, the lobbying group for chief executives. The Roundtable has been lobbying against proxy access since the idea surfaced. Also, foes of shareholder access have threatened to take the SEC to court if the agency dared to let the owners of a business actually nominate directors.

In the pending financial reform, both chambers of Congress clarified that the SEC is entitled to write such rules. However, Senator Christopher Dodd, with the apparent backing of the White House, pulled the rug out, rewriting the provision so that only a single shareholder with 5 percent of the stock could gain proxy access.

Big Boys

Why is the White House siding with the big boys and against open, democratic corporate elections? Shareholder access is a crucial reform. The real impact wouldn’t be the handful of dissident candidates who actually won. It would be the realization by every director, that, potentially, he or she could be replaced by majority vote. Sounds pretty American to me.

Proxy access is the best weapon to curtail excessive executive pay. Compensation committee chairs who ladled out huge contracts would be especially vulnerable. Perhaps that’s why the Roundtable is so afraid of a fair election.

Similarly, limits on financial leverage are the surest route to curtailing credit bubbles. Opportunities for financial reform don’t arise very often. The 2008 meltdown presented Congress with a golden opportunity. It would be a shame if they got this close and knuckled under.

Roger Lowenstein, author of the just-published “The End of Wall Street,” is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Roger Lowenstein at elrogl@hotmail.com

To contact the editor responsible for this column: James Greiff at jgreiff@bloomberg.net

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