This document is available here as an Adobe Acrobat PDF.

Peter J. Wallison, AEI's Arthur F. Burns Fellow in Financial Market Studies, evaluates government policies and pending legislation with an eye to freeing markets from excessive regulation. Three of his recent articles illustrate the range of his work. The first, which appeared in American Banker, argues that legislation designed to prevent certain companies from owning industrial loan companies will deprive consumers of lower-cost financial products and will protect the banking industry from much needed competition. An article in the Financial Times looks at the UK system of principles-based regulation and argues that, in light of the U.S. litigation and enforcement system, our rules-based system gives more freedom to those who are regulated. A third article, in the Wall Street Journal, takes the Securities and Exchange Commission to task for continuing to press for more independent directors on mutual fund boards. Wallison argues that the role of mutual fund directors in approving the fees of investment advisers discourages price competition and keeps mutual fund fees high. If investment advisers could set their fees, price competition would develop in the industry. More independent directors will keep this from happening, making the problem worse.

Carveout Reveals ILC Bill's True Nature

A version of this article appeared in American Banker on June 29, 2007.

July 2007

The House of Representatives has passed H.R. 698, legislation that is intended to prevent companies that receive more than 15 percent of their revenue from "commercial activities" from owning an industrial loan company (ILC). ILCs have many of the powers of banks, including the ability to take deposits backed by the Federal Deposit Insurance Corporation (FDIC). This act demonstrates beyond any reasonable doubt the hollowness of Congressional pretensions to be protectors of U.S. consumers in general, or of the "American family" in particular.

While claiming that the legislation is based on the principle of separating banking and commerce, the sponsors have made clear that they are protecting the banking industry against competition that might bring down financing costs for ordinary Americans. In the end, the legislation is not good either for working American families or the banking industry.

The Separation of Banking and Commerce

To push this bill through the House, the sponsors endlessly invoked the so-called principle that banking should be separated from commerce. This notion rests on the proposition that banks, as federally backed lenders, must be protected against exploitation by commercial firms in two different ways.

A commercial firm, it is argued, could abuse a bank it controls by forcing the bank to lend on favorable terms to the parent or by preventing it from lending to the parent's competitors.

In addition, a commercial firm might be able to exploit the bank's connection to the banking safety net by using the bank for a bailout if the parent gets into financial trouble.

Following out this idea, the bill's sponsors drafted legislation that would allow the FDIC
to deny applications by any firm that was engaged to a substantial degree in commercial activities. Up to this point, there is a surface consistency to the legislation. If one really believed that affiliation with a commercial firm would indeed be a threat to the federal safety net--a very doubtful proposition, by the way, since it depends on several different violations of law--limiting connections between banks and commercial firms would make sense.

Favoritism and Inconsistency

Once the bill was passed, it became clear that it was nothing more than another weakly disguised effort to protect a favored industry.

Thus, the bill's principal sponsor, Rep. Barney Frank (D-MA), let it be known that, if necessary to obtain Senate approval, automobile companies might be allowed to acquire ILCs. Huh? Are automobile companies not commercial firms? And would their acquisition of ILCs not violate the so-called separation of banking and commerce?

Surely, if you believe that commercial firms will misuse their banking subsidiaries, there is no reason to assume auto companies will be different. But if opening ILC ownership to auto companies raises questions about the bona fides of this legislation, the reason for doing so removes any doubt. U.S. auto companies, as is well known, have been taking a competitive beating from foreign manufacturers and are financially--even worryingly--weak. The industry was singled out for a special exemption because Frank knows that a concern for the welfare of this industry can bring in some votes in the Senate.

The notion that financial weakness is a reason for owning an ILC, of course, completely undermines the idea that the separation of banking and commerce is intended to prevent the exploitation of the federal safety net. For decades, the Federal Reserve Board has justified its regulation of bank holding companies as necessary to ensure they will remain sources of strength for their subsidiary banks. But now an important member of Congress is suggesting that a parent company's weakness will be a source of strength in its application to acquire an ILC.

Obviously, allowing weak companies to acquire ILCs is an open invitation to extend the federal safety net to commercial firms.

H.R. 698 Exposed

The offer to allow auto companies to acquire ILCs exposes the disingenuous posturing that underlies H.R. 698. The purpose of the bill was not what its sponsors told the House it was. Far from continuing the separation of banking and commerce, the real purpose was to protect the banking industry from competition from retailers and others who might offer America's working families a better financial deal.

Now that the sponsors of H.R. 698 are willing to offer special exemptions to others, the separation of banking and commerce is revealed for what it always has been: a way to protect the banking industry from competition.

But ironically, the exploited class will ultimately include the banks themselves. As was true of the railroads, AT&T, and other protected industries, the government's shelter will only weaken their incentives to innovate and make themselves relevant to consumers. The economic rents they earn today by keeping the Wal-Marts at bay through government action will attract potential competitors from outside the industry, and these competitors will develop and deploy new technology and marketing techniques that will eventually supplant deposit banking. It's only a matter of time.

Mutual Madness

A version of this article appeared in the Wall Street Journal on July 6, 2007.

July 2007

From all indications, the SEC is planning, again, to require that at least three-quarters of every mutual fund board of directors be independent of the fund's investment adviser. The D.C. Court of Appeals has twice struck down this move because the agency failed to consider efficiency, competition, and capital formation, as the law requires. But even if the agency does so this time, the new requirements will not be in the interests of investors.

Still, many readers may wonder why more independent directors are not good for investors. The answer lies in the peculiar role of directors in approving the fees of investment advisers. The system discourages price competition among advisers and keeps mutual fund costs higher than they should be. Here is how it works.

Mutual Funds in the United States

Mutual funds are corporations, legally controlled by boards of directors but managed under contracts by investment advisory firms that receive a fee for their advisory and management services. Mutual fund shares are sold at their net asset value (NAV)--that is, the value of a proportionate share of the fund's portfolio--but the NAV is reduced slightly by the adviser's fees and costs of managing the fund. Under the Investment Company Act of 1940, boards of directors must approve the fees and expenses of the investment adviser for each fund. In order to obtain this approval, the adviser submits its fees and expenses to the board, and in most cases the board determines, in light of these costs, whether the adviser's resulting profit is "reasonable."

If this sounds familiar, that is because this cost-plus system is substantially the same as the way that electric rates are determined by local utility commissions. As economic studies have shown, however, cost-plus ratemaking creates no incentive for efficiency or cost-cutting on the part of the regulated entity. The same problem exists in mutual fund pricing: the adviser has little incentive to lower its costs. If it does so, its profit percentage will rise, and the board may require a cut in fees to keep the adviser's profits within the range that the board considers reasonable. In addition, if the adviser takes the risk of reducing its costs and succeeds in attracting more investors, the board may require the adviser to lower the advisory fee further, because the adviser is now thought to be profiting from economies of scale.

By stunting the adviser's incentive to cut costs, this system reduces the likelihood that price competition will develop among advisers, and that is precisely what we see when we look at mutual fund costs. The mutual fund industry has a highly competitive structure--with about 500 fund groups managing $10 trillion in assets through more than 8,000 funds--yet there is a wide disparity in the costs paid by investors for advisory services to their funds. Among a sample of over 800 ordinary equity funds listed in Morningstar, for example, there is a difference of nearly 300 percent between the lowest-cost fund and the highest. There are also disparities almost as wide among the largest and most competitive funds and fund groups. These disparities do not correspond to performance, and even exist among index funds, where there can be no significant differences in performance.

Mutual Funds in the United Kingdom

The United Kingdom presents an instructive contrast. There, investment advisers can establish their own fees without the intervention of a board of directors. Yet the dispersion of prices in a sample of more than 450 UK equity mutual funds is much tighter than in the United States--about one-third the difference in the U.S. group. Also, a 2005 Lipper report compared the pricing of equity funds sponsored by six large U.S. fund managers that also sponsor equity funds in the UK. The average cost for their advisory services in the UK differed in this study by not more than 10 basis points, while the difference was as much as 55 basis points for their U.S. funds. These comparisons suggest that the cost-plus system in the United States is impairing the ability of mutual fund advisers to compete on price.

Why Should the Average American Care?

This is a significant public policy issue. Millions of American families rely on mutual funds for their retirement, and even small differences in costs, over time, can have a major effect on investment results. Recognizing this, the SEC has attempted for more than forty years to reduce the wide disparity in mutual fund pricing by empowering and increasing the independence of mutual fund boards. This was supposed to give directors more leverage in negotiating fees with advisers. This policy is a loser, as the experience of regulated utilities shows. It is not the power of the rate-maker that is important--utility commissions have plenty of that--but the fact that the regulated entity has no incentive to reduce its costs.

In 1992, the SEC staff recommended eliminating the rate-making authority of the mutual fund board of directors, but the commission never acted on this proposal. Instead of plodding ahead with a failed solution--increasing the independence of boards--the SEC should take seriously the fifteen-year-old recommendation of its own staff. Freeing investment advisers from the shackles of cost-plus rate regulation will allow and encourage investment advisers to compete on price, with the same effect for mutual fund advisory costs as the elimination of rate regulation has had for securities brokerage, air fares, and long-distance telephone rates: more competition, more innovation, and lower costs for the investing public.

America Will Prefer to Rely on Rules, Not Principles

A version of this article appeared in the Financial Times on July 6, 2007.

July 2007

Interest in principles-based regulation and accounting is growing among U.S. policymakers and commentators--and understandably so. The Financial Services Authority (FSA) styles itself as a principles-based regulator, and that looks wonderfully refreshing to individuals and companies that have had to deal with the rigid rules enforcement of the SEC. Regrettably, however, the latest flirtation is likely to come to nothing. The political, cultural, and legal environments in the United States seem unsuitable for a regulatory or accounting regime that works on the basis of principles rather than rules.

The principles-based concept has two elements: principles that govern how regulators act and outcome-oriented principles that might supplant detailed rules as guidelines for auditors and regulated companies. The FSA has both, and the concept of restraining regulatory discretion within certain channels, or focusing on certain goals, has real merit. The problem for the United States arises with the second element.

Why the United States Prefers Rules over Principles

One of the characteristic features of U.S. political life is an instinctive distrust of discretionary power. Americans like to be free of controls, and a rules-based system accommodates this preference. Although detailed rules may be made by the Financial Accounting Standards Board, the SEC, or the Internal Revenue Service, their interpretation is left to those who must comply with them. This leaves significant room for self-determination. In a principles-based system, how a principle will be applied remains at the discretion of the regulator. Thus, ironically, given any regulation at all, a rules-based system offers more freedom for those who are regulated.

But apart from this, principles-based regulation reduces the rules transparency essential for a competitive market. A rules-based regime tells everyone what is required to enter a field and compete. A principles-based regime is open to interpretation by a regulator and could be used to deny entry to would-be competitors. A recent example is Wal-Mart's effort to acquire an ILC. The U.S. banking industry strongly opposed this, and--even though there was no legal authority to do so--the Federal Deposit Insurance Corporation, under industry and Congressional pressure, imposed a one-year moratorium on applications by retailers such as Wal-Mart to give Congress time to enact restrictive legislation.

If this is what occurs when there is no authority at all to restrict entry, imagine what would happen in a principles-based environment in which a regulator has the discretionary authority to interpret its regulations so as to prevent new competitive entry.

Then, too, the U.S. legal system is, to say the least, not hospitable to principles-based accounting or regulation. A principles-based regime may work if the only enforcer is the regulator and if that regulator--like the FSA--is more interested in achieving compliance than imposing fines and penalties. But public companies and securities companies are subject to civil enforcement actions by the SEC, criminal enforcement by U.S. attorneys, criminal and civil enforcement by state attorneys general, and private class actions in both state and federal courts. Banks and insurance companies are subject to essentially the same array of public and private enforcers. In this unwieldy and enforcement-oriented structure, a principles-based system would open new doors to litigation and liability.

Nor can a compliance-oriented regime like the FSA's work in the presence of the private class action system that continues to flourish in the United States. By definition, private class actions are outside the range of government or regulatory policy. The courts and Congress have found it almost impossible to restrict the scope and cost of private class actions under a single SEC rule, the famous 10b-5. It is not hard to imagine the mischief that might be made by class action lawyers if they were gifted with a whole series of SEC rules that were similarly broad and malleable.

This raises the final point: a rules-based system, whether for accounting or regulation, has a safe harbor effect. If one complies with the rules, there is some degree of absolution. This seems essential in the litigious environment of the United States. Certainly, as in the case of Enron, rules-based regimes are subject to abuse by those who use the rules as a roadmap for deception, but given the political and legal systems that prevail today in the United States, most U.S. companies would probably prefer a fully transparent and certain system of rules.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Market Studies at AEI.

 This document is available here as an Adobe Acrobat PDF.