Obama Proposal Fails to Deal with Shroud of Secrecy Surrounding Financial Industry

President Obama’s sweeping proposal unveiled yesterday for an overhaul of the financial industry is currently missing a critical piece without which its success could be in jeopardy: It fails to provide for clear disclosure to consumers regarding the failure risk of their financial institutions.

Instead, it leaves in place a shroud of secrecy that surrounds the nation’s banks, insurers and broker-dealers, whereby consumers are

• never allowed to find out if their bank is on the FDIC’s list of problem banks;

• always denied access to the banking regulator’s confidential CAMELS ratings on the relative financial weakness or strength of their bank;

• unable to determine the relative danger of more than$180 trillion in notional value OTC derivatives held by America’s largest commercial banks;

• routinely denied access to the insurance commissioners’ risk-based capital measures of their insurance companies;

• routinely given misleading information regarding the protections afforded by state guarantee associations that cover insurance policies;

• routinely denied access to critical financial information regarding the nation’s privately held broker-dealers;

• routinely told by government and industry officials that institutions known to be on the brink of failure are “absolutely safe”; and

• as a rule, kept in the dark regarding the relative risk of financial failures.

This shroud of secrecy is justified as a way to help protect the financial system from withdrawals by consumers or from panic selling by investors. But throughout the recent financial crisis, it has failed repeatedly to accomplish that goal.

Moreover, with this shroud of secrecy in place, there is a grave risk that the Obama administration’s proposal for a regulatory overhaul of the financial industry could

• bring far greater costs to taxpayers;

• increase the regulatory burden on the financial industry; and

• do little to reduce the danger of severe financial losses by millions of American savers, investors and policyholders.

In contrast, with this shroud removed, consumers can be empowered to

• make more prudent, informed decisions;

• vote with their dollars, rewarding stronger and more worthy financial institutions with their business; and

• greatly reduce the costs to taxpayers, the burden of regulation, and the risks to the financial system as a whole.

It is behind the shroud of secrecy, often fostered and blessed by government, that America’s financial institutions — entrusted with the safekeeping of trillions of dollars — have had the opportunity to grow into mammoth risk takers. And it’s behind the shroud of secrecy that the entire financial system has been placed in jeopardy. As long as the shroud remains largely in place, it will be difficult to prevent financial institutions from finding new dangerous avenues for rapid growth of high-risk ventures.

Why The Official Shroud of Secrecy Is So Dangerous

In our white paper delivered at the National Press Club on March 19, 2009, “Dangerous Unintended Consequences: How Banking Bailouts, Buyouts and Nationalization Can Only Prolong America’s Second Great Depression and Weaken Any Subsequent Recovery,” we demonstrate that

• major financial institutions, including Citigroup, Wells Fargo and JPMorgan Chase, are at risk of failure with unusually high exposure to toxic assets and/or to the risk of default by derivatives trading partners;

• a total of 1,568 banks and thrifts are at risk of failure with assets of $2.32 trillion due to weak capital, asset quality, earnings and other factors;

• there is no official disclosure of these risks;

• past attempts by government and industry to hide or disguise the failure risk of financial institutions merely helped to create the panic they sought to prevent;

• it is a grave error to allow financial companies to market themselves as “safe” despite high-risk investment portfolios, a combination that has historically attracted a large number of Americans like sheep to slaughter;

• under the shroud of secrecy, many industry players can continue to market their products as “safe,” offer substantially higher returns, take away business from healthier competitors, and grow into behemoths;

• the business model of Wall Street rating agencies supports the shroud of secrecy and facilitates the marketing of supposedly “safe” high return products that undermine the financial system; and

• when pent-up truths are finally revealed, bad numbers are worse, the shock is greater and the reaction of the public is more panicked than it might have been otherwise.

Our Past Recommendations for Better Disclosure of Failure Risk

It was with these issues in mind that:

• In our white paper delivered to the Senate Banking Committee and House Financial Services Committee on September 25, 2008, “Proposed $700 Billion Bailout Is Too Little, Too Late to End the Debt Crisis; Too Much, Too Soon for the U.S. Bond Market,” we recommended Congress should clearly disclose to the public that there are significant risks in the financial system that the government is not able to address.

• In our white paper submitted to the Securities Exchange Commission (SEC) on May 2, 2003, “Why Reforms Don’t Adequately Protect Investors,” we recommended full disclosure of conflicts of interest underlying Wall Street research reports, bond ratings and credit ratings.

• In our statement to the SEC of December 16, 2002, “Conflicts of Interests at NRSROs,” we recommended that all Nationally Recognized Statistical Rating Organizations (NRSROs), including A.M. Best & Co., Standard & Poor’s, Moody’s and Fitch, be required to operate without conflicts of interest in their business model or lose their NRSRO designation.

• In our white paper distributed to the U.S. Senate on July 5, 2002, “The Continuing Crisis of Confidence on Wall Street,” we recommended that the SEC and Congress more clearly charge auditing firms with the responsibility to warn shareholders of suspected accounting manipulations and financial difficulties at audited firms.

• In our white paper presented at the National Press Club on June 11, 2002, “Crisis of Confidence on Wall Street,” we recommended investors be provided a “Truth in Brokerage” disclosure regarding the nature of stock ratings and the track record of research analysts, the legal history of individual brokers and firms, and the financial stability of the broker-dealer. Further, we recommended clear standards and procedures for full disclosure, including: comparability to other brokers and firms; disclosure at the point and time of sale; consumer education programs that disclose and explain all significant risks and drawbacks; distribution to the public in a standard format with standard procedures; and inclusion of all information available to regulators and self-regulatory bodies regarding.

• In our testimony before the Senate Commerce Committee on May 7, 1991, we recommended that Congress legislate full disclosure rules for the insurance industry. Our concluding statement then is the same as our concluding statement today:

“The most cost-effective vehicle for improving the long-term health of the [financial] industry — and for giving consumers the protection they need — is the dissemination of easy-to-understand, balanced information. Armed with the facts, the consumer will naturally vote with his dollars, choosing stronger companies if safety is his first priority, or favoring the higher risk companies if his primary concern is low cost and big benefits. Risk is not necessarily bad, provided it is properly disclosed to the consumer. … The best regulatory body in the world is the public. But to do their job efficiently, they need to have the facts.”

Unfortunately, today, 18 years later, they still don’t have those facts. Quite to the contrary, the shroud of secrecy surrounding the financial industry is both darker and more dangerous. Unless the new Obama proposals include strong provisions to remove it, the next round of reform will be no more successful than the prior reform efforts reviewed in our white papers and Congressional testimonies cited here.