Optimal Rules of Governance to Compete Globally

January 29, 2010

Sankarshan Acharya
Pro-Prosperity.Com and Citizens for Development


                                                                                               

January 30, 2010

To:     Honorable President Barack Obama

Cc:    Honorable House Speaker Nancy Pelosi

Honorable Senators Harry Reid, Richard J. Durbin and John McCain

Honorable Chairman, House Oversight and Government Affairs Committee

Honorable Chairman, Financial Crisis Enquiry Commission

Sub:     Optimal Rules of Governance Needed to Compete Globally 

Dear President Obama,

1.                   A Fundamental Problem in the Current Financial System

A financial holding company (FHC) can adopt a highly leveraged short-selling strategy as follows:

1.       Form a legally permissible, firewalled, bankruptcy-remote entity (onshore or offshore) with some equity capital from the parent FHC and additional debt obtained from one of its insured bank subsidiaries.

2.       Let the subsidiary sell securities short, massively.

3.       Plow all profits from the subsidiary as long as profits are being made to the parent FHC.

4.       Legally liquidate through Chapter 7 the assets of the subsidiary, when the subsidiary turns deeply insolvent and is no longer profitable. 

Under Chapter 7 Bankruptcy Code, the FHC, as the creditor of its subsidiary, has complete discretion about how the assets of its insolvent subsidiary will be appropriated.  A rational FHC will legally sell the subsidiary’s long positions for cash and write off its short positions to avoid the obligatory losses.  But in writing off its legal obligation of redeeming the borrowed securities sold short, the FHC circumvents the SEC rule on short-selling. 

Our laws and procedures thus permit the FHC to transfer massive wealth from stockholders (the entrepreneurs and investors) who panic in response to falling prices induced by highly leveraged short-trading strategies and dispose of their holdings at deep discounts to the FHC.  The FHC can easily scare the shareholders by submitting large sell orders at prices slightly above the latest trading price.  The FHC can submit very large sell orders because it controls large taxpayer-insured bank deposits.  Of course, when the FHCs trade against each other, some of them lose massively and approach the Congress for a bailout.

Recall how Merrill Lynch was desperate during 2007 to merge with Wachovia for survival based on the federally insured deposit base of the latter, or how Citigroup fought to have Wachovia’s deposits, or how J. P. Morgan contrived to acquire Washington Mutual’s deposits, or how Goldman Sachs and Morgan Stanley had to become bank holding companies for survival based on federal funds borrowed through Fed discount windows, or how the FDIC and taxpayers had to standby as guarantors of debt issued by the bank holding companies. 

The FHCs will obviously and rationally acquire as big federally insured deposit/fund bases or guarantees as they can to facilitate transfer of the hard-earned savings of the vast majority of investors via highly leveraged short-selling. This can happen during the “normal” times while the economy grows and when the guardians of the system can easily brand the complainants as “whiners.” 

2.                   Erosion of National Competitiveness Due to the Fundamental Problem

A nation’s competitiveness can be measured by the net exports and the value of currency.  The US dollar has been falling and is poised to fall further.  The net US exports have remained significantly negative with no signs of improving.  Experts suggest that even a greater fall in the value of dollar may not be able to balance the trade for the US.  How did this happen?

As the “whining” owners of entrepreneurial companies face crashes in their stocks due to short-selling by the bank traders, they tend to emigrate to places like China, India and Eastern Europe where such highly leveraged short-selling schemes are impossible because these countries have effectively adopted “Safe Banking” policies.  To compete, large companies like GE, Intel and Cisco have to relocate some of their operations overseas.  This process over time has led to a sustained trade imbalance and a permanent loss in good jobs in USA. 

To enhance competitiveness and to preclude an impending financial crisis that I saw brewing within a prosperous banking industry, I had proposed the “Safe Banking” policies to the US Congress in March 2003.  I had no hope of acceptance of optimal policy recommendation from a “whiner” made during a “normal” period of economic growth.  I had in fact predicted in 2003 that the Congress would not enact a Safe Banking law until the taxpayers lost trillions of dollars.[1]   

I have written about the above short-selling strategy and the preemptive optimal policy in my book, Prosperity, scripted in 2003 and published in 2005.[2]  I have articulated the same in a widely circulated paper later in November 2007.  I have also argued in a policy memo how the taxpayers were unknowingly committing financial suicide by having the federally insured banks lend insured deposits to privately-held hedge funds sponsored by the same banks.[3]  This policy memo was circulated among prominent members of the US Congress including you, when you were a Senator from Illinois, and President Bush in late 2007. 

I am happy that Prime Minister Gordon Brown of UK has embraced my recommendation about banning the availability of federally insured deposits to private hedge funds.  Mr. Brown has correctly voiced his anguish over the meltdown due to the irresponsible and undisclosed lending in an opinion piece in Washington Post in October 2008.  Mr. Paul Volcker has also embraced the rule for barring availability of taxpayer-insured funds to hedge funds and private equity funds sponsored by banks.[4]

Whether the rule is branded as “Acharya Rule” or “Brown Rule” or “Volcker Rule” or “Acharya-Brown-Volcker Rule” is immaterial to someone who believes in and performs selfless research to serve mankind.  We have to just ensure that crediting an idea that originates from someone’s research to someone else is consistent with the intellectual property and copyright laws.  Incidentally, my book argues why these laws should be repealed for better service to humanity.  Profound ideas and innovations (exclude mine!) have historically originated from an innate juggernaut of creativity and innovation by people who longed for no pecuniary incentive.  It is befuddling that the least creative and non-productive bank traders continue to seek gargantuan bonuses to perform disservice to the real producers of globally competitive goods and services.

3.       Agreement Reached

It seems to me that all the members of Congress have now agreed (or at least are unwilling to oppose publicly) that taxpayer-insured funds should not be made available for trading by highly leveraged private hedge funds or bank-sponsored equity funds.  This commonly accepted policy goal can be accomplished by barring federally insured banks from operating their own hedge funds or from sponsoring (through lending of federally insured deposits) private equity funds. 

4.       Volcker Rule Doesn’t Solve the Fundamental Problem

The other element of “Volker Rule” that you have pronounced on January 21, 2010 will still permit banks to engage in trading in behalf of their clients.[5]  This would then mean that a bank can sell a security to a client with an intention to buy the same security within a reasonable time from someone else in the market.  The client could be a mutual fund, hedge fund, private equity fund or some ordinary account holder.  During this time the bank will remain short, which is legal under the current SEC rule as it is not a naked short position because the bank effectively borrows the security from its client. 

This element of the “Volker Rule” will thus not solve the fundamental problem bedeviling US enterprise, investment and export growth. 

5.                   Optimal Rules of Governance Needed to Compete Globally

To compete globally, we should ban short-selling of securities and trading-profit based bonuses in banks. 

Better still is to shoot for a new charter of Safe Banks.[6] 

We should also urgently institute a new measure of economic prosperity: growth in net assets of the bottom 90% or so.  This measure would be an early warning signal for an impending depression, as I have argued in my book and in numerous memos to you and to the US Congress. The current system of measuring prosperity by economic growth will continue to mask the truth about whether widespread household depression is brewing within a growing economy. 

My goal is to convey that the above Truths be accepted as new tenets of optimal governance.  We will then help emancipate the vast majority who innovate and produce from the few who tend to dominate by adopting laws underwritten unknowingly by the very people who are supposed to rule in a democracy. 

With profound regards,

Sankarshan Acharya

PS: Mahatma Gandhi has once described a test of the Truth (and I paraphrase): If and when the Truth is presented, "they" will first ignore it.  Then "they" will say, maybe there is something in it.  At the end, "they" will concede by proclaiming that "they" knew it all along.  By "they," he meant the beneficiaries who served their self interests by subjugating the vast majority through suppression of the truth.  

I have devoted my research since 1989 to elimination (efficient resolution) of moral hazard in the banking industry, precisely to preclude recurrence of the Great Depression.  I completed this research, successfully in my view, in 1994 with the publication of a working paper while I was still at the Board of Governors of the Federal Reserve System.[7]  This paper is still under review, but several sister papers on relevant optimal policies have been published.  In particular, “Safe Banking” policies published in 2003 will obviate the ban on funding taxpayer funds to private hedge funds.[8]   Policies in this paper have been more robustly developed in a recent paper published in 2008, “Safe Banking to Avoid Moral Hazard.”[9] The memo faxed to the President and Congress on January 17, 2010 reiterates the necessity to enact some of these policies urgently.



[2] http://pro-prosperity.com/Citizens%20Publishing/TableOfContents.pdf

[4] To the best of my knowledge, there is no publication after the Glass-Steagall Act was repealed in 1999 to advocate banning the usage of the federally insured bank funds in private hedge funds managed by the same banks, until I widely distributed my paper in November 2007.  In fact most pundits in academia as well as Wall Street argued how safe and self-disciplined the capital markets had become to pave the repeal of the Glass-Steagall Act.. 

[5]I have not proposed this element of the “Volcker Rule.”

                                                                                                January 17, 2010

To:       Honorable President Barack Obama

Cc:       Honorable House Speaker Nancy Pelosi

Honorable Senators Harry Reid, Richard J. Durbin and John McCain

Honorable Chairman, House Oversight and Government Affairs Committee

Honorable Chairman, Financial Crisis Enquiry Commission

Sub:     Reforming the Financial System to protect Taxpayers and Productive Households

Dear Honorable President and Members of Congress,

Under the current financial system, in every five to seven years, (a) the capital market custodians (top bankers) scare the households (through short-selling strategies) to sell the risky assets and then to transfer the atrophied household savings to “riskless” bank deposits or money market funds, (b) the economy shrinks, and (c) the Federal Reserve responds by lowering the interest rate on the decimated household savings. 

In this system, households are flogged by both the capital market honchos and the Federal Reserve.  The result is enervated savings, destruction of earned capital, severe underemployment and rising unemployment, which pave the way for yet another Great Depression. 

The households comprise innovators, scientists and producers of globally competitive goods and services.  They produce food, technology and engineering goods.  They serve and secure the nation.  They protect what America stands for: individual liberty.  Yet, their retirement savings are wangled away by indolent, unproductive bank traders.  Wangling such savings (repertoires of hard work), even surreptitiously, amounts to subjugation of the true innovators and producers – who keep the nation strong and secure - by those who do not produce anything but weaken the nation willy-nilly. 

A preemptive policy needed now (and should have been adopted in 2008) to avert another Great Depression was already communicated by yours truly:

 

1.      Use Fannie Mae and Freddie Mac to refinance at 2.25% all the good loans held in the portfolios of commercial banks.  This home mortgage rate is simply the Federal Funds rate (0.25%) plus a premium of about 2% that is sufficient to fetch a decent return on banking service of loans. 

This policy will impose no risk to either the GSEs or the taxpayers because the loans are good.  It will induce the commercial banks to compete with Fannie and Freddie to refinance the good loans at lower rates.  Such competition will lower the mortgage rates dramatically for most borrowers.  Falling mortgage rates will eventually raise the home prices.  Rising home prices will engender pervasive optimism.  More tangibly, it will lower mortgage payments and generate fresh household savings which will stimulate the economy as optimistic households begin to spend again.  Rising home prices will lower loan losses for banks and thus reduce the future bailout risk to taxpayers. 

2.      Ban short-selling to forever close the path to another Great Depression.[1]

Currently, bank traders – who do not produce globally competitive good and services – have two potently destructive instruments at their disposal: (a) short-selling and (b) massive taxpayer-insured bank funds.  They use these instruments to make capital markets highly volatile in order to nibble away the hard-earned savings of the innovators and producers of globally competitive goods and services. 

The bank traders are induced by trading-based bonus schemes to wangle and ultimately destroy the wealth created by the productive households.  They do not seem to worry a bit about ruining the very financial institutions which provide them the berth for such trading or the very taxpayers who have unknowingly and naively underwritten such financially suicidal instruments for the traders.   It is as if to add salt to the injury of the taxpayers and productive households, the Federal Reserve and the US Treasury provide the ultimate security to the bank traders by transferring taxpayer funds to the ruined financial institutions. 

Short selling is the most potent instrument available to bank traders.  Individual households can also sell securities short, but they invariably lose when massive taxpayer-insured bank funds are available to bank traders.  When top institutional traders lose (as they did during 2007-08), their patrons (the banks) lobby for bailout funds created-borrowed by the government.  So, the current financial system does not serve the taxpayers or the productive households who indeed prop the government and the nation.  The current system is designed to cause Great Depressions by gradually weakening the economy and the nation. 

Banning short-selling will help serve the taxpayers, producers, government and country.  A nation should not predicate its policies on thoughts or advices of self-serving bank traders that short-selling is necessary to hedge risk.  Sure it hedges the risk of the nonproductive bank traders and rewards them handsomely, while ruining the hard-earned savings of the real producers who prop the nation and the economy.

3.      Ban bonus schemes tied to trading profits in directly insured and tacitly protected (too-big-to-fail) financial institutions.[2]

These policies will also obviate the vindictive knee-jerk actions like taxing bank executive bonuses or levying bank liabilities.  Seeking retribution from bankers, who act optimally from the point of view of their businesses, is not sanguine for a nation.  If anyone is to blame for the disaster, it should be the Congress and successive Administrations for not adopting policies which are optimal for taxpayers.   

Aren’t these policies necessary for a nation to compete and stay innovative, creative and productive?  Why are we then scared to adopt policies that are necessary and good for the country?  

 

Top bankers have succeeded in keeping the current financial system intact to continue the unfettered wangling of savings of the producers of globally competitive goods and services.   They have succeeded in scaring the lawmakers to not change the system. 

The households are, however, not scared of reforming the system.  They are angry with the Congress and rightly so.  They are longing for a reformed system that rewards innovation and that bans indolent schemes (like short-selling) and back-door protection of bank traders designed to surreptitiously wangle the savings of the true innovators and producers.  They are longing for a reformed financial system that will make the nation stronger and resilient, consistent with their nonpareil achievements like septa bites of broadband transmission per second and the cheap super computers on household desktops.  Such longing is consistent with the dream of the founding fathers and the constitution. 

With profound regards,

Sankarshan Acharya



[1]“Sub-optimality of short-selling,” http://www.pro-prosperity.com/Research/Sub-Optimality%20of%20Short%20Selling.pdf

[2]“Optimal CEO compensation in best national interest” http://www.pro-prosperity.com/Research/OptimalCEOCompensation.pdf