Kogod Now - Fall 2013 by American University, Kogod School of Business

Financial Crimes Scandals, regulation lead to rise of forensic accounting.

The American University Kogod School of Business | FALL 2013

Reliving Lehman Five years post-collapse, what do we know?

Inside Dodd-Frank An author of the act examines "too big to fail."

The Regulation Issue 1 from the dean 2 The Dawn of the Forensic ACCOUNTANT 6 It’s All Roses for Well-Connected Boards 8 Homegrown Entrepreneurs 14 Tune In to PLCY Radio COVER STORY 16 The Five-Year Mark 25 Business Bribes: Who Pays Them, and Why? 26 Why Emerging Economies Should Welcome Foreign Banks 28 How to Save Your Stock When the SEC Comes Calling 34 Congress’s Failing Foresight KOGOD NOW FALL 2013 | kogodnow.com

36 The Business of Government Consulting Kogod Tax Center 38 Exorcising the Tax Code kogod standout 42 Finding Opportunity Underwater 44 What Hospitals Can Learn From Hotels Practitioner Perspective 46 An Inside View of Dodd-Frank

48 Guilt by Association

From the Dean Enshrined within the United States Constitution, the Commerce Clause is one of our nation’s founding principles. It conveys to the federal government the right to regulate commerce, both foreign and domestic.

Academics and practitioners alike are trying to determine if the impact of Dodd-Frank is what Congress intended—much as they do with the Sarbanes-Oxley Act of 2002 (SOX), more than 10 years after its passage. Both acts have farreaching implications for businesses in how they pursue opportunities and report on their activities. Professor Gopal Krishnan contemplates whether SOX has changed the relationship between corporate boards and their CEOs, while Executive-in-Residence Casey Evans, who led the fraud investigation team against Bernie Madoff, considers the growth of the forensic accounting industry in its wake. Ever wondered whether justice is duly served to those corporate executives who misstate their companies’ financial earnings? So did Associate Professor Gerald Martin. He uncovered an interesting monetary incentive for firms’ cooperation when their leaders are charged with such crimes. Further afield, Associate Professor Robert Hauswald and Assistant Professor Valentina Bruno examine the impact foreign banks have on emerging markets, and determine that their influence on local access to credit is often misunderstood. We believe a deep knowledge of the regulatory framework in which business operates is an imperative for our students. We have spent the past year carefully revising our curricula to ensure that Kogod students have personal experience dealing with this complex environment before they graduate. A Kogod classroom is transformed through the research and expertise of our faculty; the handson ventures developed with market leaders; our access to resources only available in Washington, DC; and the diverse perspectives and backgrounds our students bring to class. Through the continued work of our faculty to understand and contribute to the regulatory landscape, we will graduate students who are better prepared to create the commerce of tomorrow.

Letter by Michael j. ginzberg Dean, kogod school of business

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The trouble begins when you try to define “commerce.” In 226 years, we have yet to reach a consensus. The resulting legacy of regulation leaves few with clarity, and many confounded. Nothing unifies a room full of business leaders and politicians faster than saying that our nation’s regulatory system is broken. Just don’t ask them to agree on which regulations need to be changed or eliminated. Understanding the impact regulation has on business is an evolving area of academic study. Since September 2008, the rapid changes in market regulations, particularly financial, have resulted in a wealth of changes to how businesses operate—and how federal agencies regulate. As markets continue to shift and stabilize worldwide, hindsight is still not 20/20. We continue to evaluate the catalysts of the worst crisis since the Great Depression, and we examine whether our regulatory reactions are helping or hindering economic recovery. Washington insiders are often accused of being too close to an issue or interest to have a balanced perspective. However, we believe that two of our faculty members featured in this issue are uniquely positioned to reflect from the “inside out,” hailing as they do from the Board of Governors of the Federal Reserve System and the Commodity Futures Trading Commission. Robin Lumsdaine joined the faculty in 2008 as the Crown Prince of Bahrain Professor of International Finance, after serving for several years as Director of Banking Supervision and Regulation at the Fed. She provides a fascinating reflection on the five-year anniversary of the collapse that began with Lehman Brothers, the largest corporate bankruptcy in US history. James Moser, former Commodity Futures Trading Commission economist and executive-in-residence since 2012, considers whether the freeform oversight given to agencies by the Dodd-Frank Wall Street Reform and Consumer Protection Act is failing to address the issue of over-the-counter derivatives.

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The Dawn of the Forensic Accountant Bernie Madoff, 150 years. Dennis Kozlowski, 25 years. Bernard Ebbers, 25 years. Jeffrey Skilling, 14 years. Walter Forbes, 12 years. Dozens of top executives are now serving prison terms for fraud, insider trading, misappropriation, and other financial crimes, while investors and employees have lost billions of dollars in stock and savings as the schemes have surfaced. A slew of financial scandals over the past two decades has prompted a flurry of accounting regulations, from the Sarbanes-Oxley Act of 2002 to the Dodd-Frank Wall Street Reform and Consumer Protection Act, as well as an increasing interest in the industry that uncovers such financial crimes: forensic accounting. “Everyone seems to be paying attention,” said Casey Evans, an executive-in-residence who led the team of investigators and forensic accountants looking into Bernard L. Madoff Investment Securities.

The Law So regulations were created. The Sarbanes-Oxley Act (SOX), enacted in July 2002, was a direct reaction to the corporate accounting and fraud scandals that resulted in billions of investor losses and shook public confidence. The act aims to protect investors from future fraudulent accounting by corporations, mandating strict disclosure procedures. Under the law, senior management officials must certify that financial statements are accurate and, along with auditors, establish internal controls and reporting methods. The act also set penalties for those who knowingly certify inaccurate financial statements or try to retaliate against whistleblowers, and it created the Public Company Accounting Oversight Board (PCAOB) to oversee the auditors of public companies. “[It] forced companies to pay a lot more attention to financial fraud,” Evans said. Regulation was added again in 2010 under the Dodd-Frank Wall Street Reform and Consumer Protection Act. Though the law’s primary intent is to prevent the risk taking and predatory lending that led to the recent financial crisis, it also addresses regulation by the SEC in light of Madoff’s $65 billion, decades-long Ponzi scheme. The SEC investigated Madoff’s company several times but never detected the largest fraud ever by an individual, which had ensnared charities, celebrities, and Nobel Peace Prize laureate Elie Wiesel alike. Title IX of the Dodd-Frank Act now requires that all auditors of registered broker-dealers be regulated

Article By Lindsey Anderson

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The scandals But first, there was Enron Corp. And Tyco. And WorldCom. And Adelphia. The companies that had once looked so promising on paper, reporting billions of dollars in earnings, began to unravel upon closer examination in the late 1990s and early 2000s. “The bubble started to burst, and frauds were exposed,” Evans said. And Enron was the star of the show. Executives at the energy company used illicit business deals and accounting loopholes to misrepresent earnings and grow the company into an enterprise reportedly worth more than $60 billion in 2000. “That was really just the culture of the time,” Evans said. “Because we didn’t have strong regulation at the time, companies could operate in a very, very gray area of accounting.” But by fall 2001, the Securities and Exchange Commission had launched an investigation into Enron; as the massive accounting fraud was discovered, the company declared bankruptcy. More than 5,000 employees lost jobs and $2 billion in pensions when Enron collapsed. Similar fraud surfaced in 2002, again resulting in bankruptcy—this time of WorldCom, which once

reported $103.9 billion in assets. Also in 2002, Adelphia, once the fifth-largest cable provider in the United States, declared bankruptcy after former CEO John Rigas and his two sons misused corporate funds and hid billions in loans and debt. Tyco International managed to avoid bankruptcy that year after CEO Dennis Kozlowski and CFO Mark Swartz received more than $150 million in unearned bonuses and loans from the company for six years.

by the PCAOB, unlike the two-person unregulated company that audited Madoff’s firm. As with all regulation, there are increased costs. Evans acknowledged that SOX can be timeconsuming and costly for a company, as it requires reviews of internals controls and examining “every step” of the accounting process “by people who usually have other jobs to do.” But the act, she said, also leaves less room for manipulation.

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The Investigators Increased regulations have led to a surge in the forensic accounting industry. The big accounting scandals of the past two decades were just the tip of the iceberg: according to Evans, there have been hundreds of cases since Enron. “You’d probably be hard pressed to find a company that doesn’t have problems,” she said. That’s why lawyers, government agencies, and companies themselves have hired forensic accountants to investigate and prevent potential fraud, bribery, and other financial malfeasance. In some cases, these companies were victims of fraud at the hands of their employees. In others, top-level managers were scamming board members, the public, or their own employees. Some companies seek to prevent violations and preemptively search for wrongdoing. Forensic accountants can also testify as expert witnesses, explaining their interpretation of financial evidence as a lawyer makes a case in court. They often work for the Big Four accounting firms—PricewaterhouseCoopers, Ernst & Young, KPMG, and Deloitte; for consulting firms such as RGL Forensics; for companies as internal auditors; or for government agencies like the FBI, the SEC, and the Consumer Financial Protection Bureau. Though the work forensic accountants does appear similar to that of auditors, there are some notable differences.

Forensic accountants “find the needle in the haystack.” Casey Evans, Executive-in-Residence

Auditors provide an opinion on whether records are free from material weaknesses, covering everything under a broader focus on the company’s financial situation. They typically do the same review of the same company every year, and often work openly with the company. Forensic accountants “find the needle in the haystack,” Evans said, often looking at one account, for example, where fraud may have occurred. They also have no prior experience with the company and tend to keep a low profile so as not to scare employees into tampering with evidence. Chelsey Fekishazy, BSBA ’08/MSA ’09, discovered that her background as an auditor was helpful in her new role as a forensic accountant. Fekishazy, who has been working as a forensic accountant at FTI Consulting for about a year, said it’s now second nature for her to make sure the proper controls are in place when she is investigating potential wrongdoing. As the forensic accounting industry has expanded, so too has the need for qualified employees. Kogod’s new graduate certificate in forensic accounting, led by Evans, seeks to address that need and prepare professionals for the growing field. The Investigation A forensic accountant’s investigation process typically goes like this: An attorney or a company hires forensic accountants and gives them an overview of the situation. The team gathers emails, documents, accounting books, bank statements—any and all paper and electronic records—usually with the help of technical professionals.

The Future In Evans’s view, the newer regulations, with newer rules to break, will likely prompt a flurry of cases in the coming years—including those brought under Dodd-Frank. Heightened awareness isn’t established overnight, nor are the results and penalties of fraudulent accounting. “It takes a little while for rules to get put in place—and also to get broken,” Evans said. Though the industry is waiting for cases to catch up with regulations, Fekishazy doesn’t worry about its potential. “There’s always fraud,” she said. “Always.”

The Clue Evidence of potential wrongdoing can be anything from questionable records to a text message, Evans said. Emails and handwritten notes have often been key triggers. “You’d be surprised by what people put in email—still.” When Evans was a fairly green forensic accountant, working at a small accounting firm in Tennessee, she discovered an email that helped move a fraud case forward. A message from the controller told

the accountant to book revenue in the wrong period. “For me, it was a big find within an investigation,” Evans said. “When you find little nuggets like that, it helps build the case.” Sometimes it can be an employee that tips off investigators. Uuljan Djangazieva, BSBA ’11, is a forensic associate at KPMG. She helped investigate a US subsidiary of a manufacturing company that allegedly stole $18 million over 17 years. The parent company, based in the United Kingdom, hired the firm to investigate the subsidiary before an upcoming shareholders meeting. The subsidiary was buying contracts “like mail-in rebates,” receiving double the refund, Djangazieva said. The company had two sets of accounting books and an employee whose entire job consisted of tweaking records and removing refunds and kickback—an obvious red flag for Djangazieva. Proof of wrongdoing came primarily from interviews, she said, and the chief financial officer seemed almost proud of being able to keep up the game for 17 years. “It was part of the corporate culture of that company,” Djangazieva explained. “Everybody was like, ‘Wait, it’s not OK to do that?’” KOGOD NOW FALL 2013 | kogodnow.com

The team then reviews the data and interviews employees to begin putting together the story and filling in gaps. Usually the interviews are conducted in a boardroom—not like the interrogation rooms seen on TV, Evans said—while lawyers for both sides are present. And sometimes there’s a language barrier. Fekishazy recently traveled to Kraków, Poland, to look into a possible violation of the Foreign Corrupt Practices Act of 1977. A subsidiary was being investigated for possibly bribing Polish groups to obtain contracts, which would violate the law. Fekishazy spent her time looking through paper copies of five-year-old receipts, books, and other paper documents—all in Polish. A Polish lawyer translated as many of the documents as possible, though the investigators had Google Translate open the entire trip, Fekishazy said. To get through the building, the subsidiary’s employees had to walk through the room where the four investigators sat, “which made things a little bit awkward,” Fekishazy said. “You need to get comfortable with being uncomfortable.” Investigations often take years. Evans worked on the Madoff case for about three years, spending six months alone in the company’s office, reviewing documents, analyzing records, and working with lawyers for the trustee and the FBI to put the story together.

It’s All Roses for Well-Connected Boards Business deals and professional relationships have always flourished in settings outside the office for instance, charity organizations, college alumni groups, and, certainly, the golf course. Yet research from Professor Gopal Krishnan suggests the social ties that individuals cultivate there have assumed new meaning in the decade since the Sarbanes-Oxley Act of 2002 (SOX). Article By Amy Burroughs

A recognized expert on auditing and corporate governance, Krishnan studied the effect that social ties between board members and CEOs or CFOs have on earnings management. He found that firms with boards that have more social connections with these C-level executives are more likely to engage in the use of such techniques, which can paint a deceptively rosy picture of the company’s financial position. “Social ties can undermine board effectiveness, because directors are supposed to provide a monitoring role,” Krishnan said. “If they are buddy-buddy with the CEO or CFO, it would become very difficult for them to strictly control the senior management.” In corporate governance parlance, that means CEOs could “capture” those board members so as to pursue their own personal agendas. To reach their conclusions, Krishnan and his co-authors analyzed data from approximately 1,300 firms over a six-year period, assessing variables such as earnings forecasts and biographical information for board members and executives. Measuring Relationships Specifically, the researchers sought to measure how social ties affected three types of earnings management: 1. To avoid reporting a loss,

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2. To avoid reporting an earnings decline, or 3. To avoid failing to meet or beat analysts’ earnings forecast. Measures of all three factors confirmed that social ties “undermin[ed] directors’ formal independence, resulting in more earnings management and lower information quality in both the pre- and post-SOX time periods.” Significantly, they found that SOX appears to be working: post-2002, firms with more social ties showed a greater decline in earnings manage-

ment. All three types of earnings management declined after SOX, proportionate to the presence of social ties. The results also suggested that CEOs’ social ties, more than those of CFOs, influence earnings management. That reflects CEOs’ broader governance power, Krishnan said, as well as their larger role in selecting board members. Of course, social ties do not necessarily mean board members will go so far as to overlook outright fraud. Social connections might, however, increase their reluctance to challenge a CEO’s actions, or their willingness to “play along” when financial reporting tiptoes into a gray area. “The shared characteristics and life experiences…can also undermine, consciously or unconsciously, the ability of a formally independent director to question or disagree with a CFO/CEO’s attempt at managing earnings,” Krishnan wrote. Regulations dictate that board members must be independent—that is, they cannot have financial or family ties to a firm or its top executives. Social ties, however, are fair game. SOX’s Social Effects Krishnan found that after SOX was implemented, CEOs and CFOs chose more socially connected board members than before, presumably as a way to circumvent tighter standards for board independence. The social ties he and his co-researchers studied included shared past employers, education at the same institutions, and activities such as golf club or charity memberships. Social relationships can be a double-edged sword, Krishnan pointed out. These days, students of business and other disciplines are frequently advised to take advantage of social connections— and to network to deepen those connections even further. Young professionals learn early and often that “it’s all about who you know.” Social ties also may yield business benefits. “The better networks you have, the better you can probably identify new customers, new markets,

new products—all those things that may actually be beneficial to shareholders and the company,” Krishnan said. “The downside is that the social ties would somehow weaken the monitoring role of the board.” Weaker monitoring could translate to more aggressive earnings management, which, in turn, lowers the quality of financial reporting. That quality is critical because investors and analysts use reported earnings to gauge corporations’ financial strength. The problem is that managers have a certain amount of latitude in discretionary reporting. This allows them, if they are so inclined, to “put lipstick on a pig,” leading investors to overly optimistic projections. Krishnan gives the example of an auto manufacturer reporting estimated expenses for future warranty repairs. “Let’s say earnings are low this year,” he suggested. “You may lower the estimate from 5 percent to 3 percent, and that would boost your earnings because you’re reporting less expense. You can play with the estimate.”

“CFO/CEO-Board Social Ties, Sarbanes-Oxley, and Earnings Management,” co-authored with K.K. Ramen, Ke Yang, and Wei Yu, was published in Accounting Horizons in 2011.

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Literature Advancement The researchers’ analysis included data from 2000 to 2007 (except 2002, the year of SOX’s enactment, to avoid possible confounding effects). They drew from databases containing firms’ annual financial information, analysts’ earnings forecasts, corporate governance control variables, and biographical data for board members and executives. They studied board size, board independence, average length of directors’ tenure, average number of other directorships held by board members, and whether the CEO also chaired the board. Krishnan’s study expanded on previous research in part by examining executives’ social ties with the entire board, not just the audit committee. The findings confirmed the importance of this broader scope, Krishnan said: “If you have a very good audit committee and the board is dysfunctional, the board can choose to ignore the recommendations of the audit committee.”

Born of a scandalous, Wild West era of financial accounting, SOX was designed to improve corporate governance and restore investor confidence. Those outcomes appear to have been achieved, Krishnan said, thanks to a sharp increase in regulatory scrutiny and the threat of lawsuits against companies that fail to comply. “I think it had a significant effect on people’s behavior,” he said. “Auditors were under a spotlight and management was subject to more scrutiny, so one would hope the financial reporting quality would improve following SOX.” Even though Krishnan’s study highlights a potential weakness in the post-SOX environment, he doubts lawmakers will expand regulation of board independence to address social ties. In addition to drawing significant opposition—and bringing out the lobbyists in force—they would find it exceedingly difficult to reach a solution that satisfied all stakeholders, he said. “You can protect independence in a number of ways, but you don’t want to go too far because then it becomes very difficult for the company to choose its board members,” Krishnan said. “You have to draw your line somewhere.” When regulators tightened the rules governing who could serve on corporate boards, they likely were aware that social ties remained a potential vulnerability, Krishnan said. They faced a major challenge, however, in how best to define independence. “The general notion was that if you make the board members independent, that would provide some oversight and increased monitoring, because that’s what directors are supposed to do,” he said. Even if regulators had an eye on social ties, Krishnan speculated, they may have underestimated just how powerful those ties could be. Currently, Krishnan is researching factors that strengthen audit committees.

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Homegrown Entrepreneurs

How do you grow, raise, and nurture a future entrepreneur or an entire generation of them?

1. What factors influence creative behavior among young people in developing countries? 2. What institutional strategies could governments use to encourage creative and entrepreneurial behavior?

An Ideal Environment? In developing nations, nurturing creativity is important because entrepreneurship is well suited to these environments, according to Edgell. For one, it is highly localized. People can spot and develop opportunities in ways that serve their communities. Homegrown enterprises often fare better than externally imposed models: “Entrepreneurship enables local people, to some degree, to assert themselves in their context and make sense of it,” said Edgell. That does not make local businesses painless to start, or grow. The usual suspects are lack of funding, weak infrastructure, unstable govern-

Article By Amy Burroughs

Accordingly, the framework addresses individual personality and cognitive processing; socioeconomic status, parenting, and local communal networks; and national systems of social, economic, and political initiatives.

Edgell strove to transcend the “WEIRD” trap— that is, the Western, Educated, Industrialized, Rich, and Democratic perspective. The concept is from a landmark 2010 article, which argues that because affluent Westerners make up the vast majority of behavioral and psychological study samples, researchers often consider them the norm when, in fact, they are least representative of the human experience worldwide. The more Edgell examined individual-level characteristics of developing nations, the more limitations he saw for future entrepreneurs. “If kids don’t have certain resources and that’s a persistent feature across the population, that’s going to be a problem,” he said. “You’re probably not going to have creative people who can be entrepreneurs.”

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“You have to have a whole, integrated view, from early childhood all the way through to young adulthood,” according to former Assistant Professor Robert Edgell. “All the attributes you would need to have young entrepreneurs cranking out new, interesting ideas that become businesses, develop countries, and employ people.” Forthcoming research from Edgell suggests that obstacles to this entrepreneurial utopia exist within all layers of society: individuals, families, cultures, and institutions. Yet these layers also harbor the seeds of opportunity. Edgell, who studies creativity and innovation, was interested in factors that help or hinder young entrepreneurs. After exploring a wide range of interdisciplinary research, he created a framework for institutional change in national entrepreneurial development. He set out to answer two questions:

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ment, and scant training—but they are not the only impediments. When Brad Fisher, SIS/MA ’13, visited Tunisia in the summer of 2012 to work with aspiring entrepreneurs, he learned quickly that a business idea embraced in one culture may be considered disgraceful in another. Fisher’s visit was aided by Kogod’s relationship with L'Institut Arabe des Chefs d'Entreprises (IACE), or Arab Institute of Business Managers. On Tunisia’s coast, Fisher met residents who wanted to start a food truck service at a beach resort. “I thought it was a good idea,” Fisher said, “but their family got really upset.” The family, university educated, expected its relatives to pursue engineering or another prestigious path. Food truck service, they felt, was shamefully beneath them. In developing nations, obstacles to entrepreneurship are plentiful, but shame, fear of failure, and the social values they reflect aren’t the obstacles that readily come to mind. Changing Top to Bottom After his time in Tunisia, Fisher spent a semester in Executive-in-Residence Robert Sicina’s practicum course on Peace Through Commerce, in which students generate business plans based on ideas that emerge from the program. Sicina selects

In developing nations, obstacles to entrepreneurship are plentiful, but shame, fear of failure, and the social values they reflect aren’t the obstacles that readily come to mind.

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Homegrown Entrepreneurs

students from American University and other US schools to work with the IACE in-country. Last year, 15 graduate students, including several from AU, visited 10 Tunisian cities—often small, rural areas—to evaluate business ideas with approximately 200 would-be entrepreneurs. Fisher traveled to Thala, Regueb, Makthar, and Ghomrassen, where local development offices were not always available. Residents did, however, have plenty of enterprising ideas. One wanted to provide finishing work for Thala’s marble industry. Others saw an opportunity to pelletize plastic bottles to make transport to recycling factories easier and cheaper. In Regueb, members of a cooperative wanted to build a factory to dry produce, enabling them to ship goods farther. Certain ideas were more promising than others. One resident, taking inspiration from a new shrimp farm announced in 2012, proposed a questionable octopus farm. Another envisioned a robot factory, despite lacking materials and technological know-how. Of course, Fisher noted, off-the-mark ideas are not limited to Tunisia. “There are plenty of bad ideas for small businesses in the US. At the same time, I was impressed with the drive of some of these people. They were really optimistic. I hope they can pull it off.” Pulling it off, in Edgell’s framework, requires top-down and bottom-up effort. To illustrate, Sicina points to the explosive growth of cell phones in Africa. In 2000, Africa had fewer than 20 million landline phones. By 2012, it had nearly 650 million mobile phone subscriptions, according to a report by the World Bank, African Development Bank, and African Union. Arguably, that development improved Africans’ economic well-being more than any program in recent memory, Sicina said, adding that the

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market—not aid organizations—drove the growth. He believes this shows that the best solutions may grow outside the institution. “You’ve got to get on the ground, in the village, getting your hands dirty.” At the same time, governments clearly have a role. As the report on Africa notes, “[government’s] larger role lies in creating an enabling environment—issuing licenses, making available rights of way, auctioning spectrum, or mandating infrastructure sharing and interconnection—that allows a liberalized market to thrive.” Tunisia’s government could arguably do more to facilitate entrepreneurs. On the World Bank’s Ease of Doing Business Index, Tunisia ranks 50th of 185 regulatory environments, down from 45th in 2012. The index measures the time and money needed to get a business up and running officially, from tax registration to building permits, relative to other countries. This year, Tunisia fell in every category except cross-border trading. “That kind of stuff needs to change,” Sicina said.

Cultural Norms and Values Given optimal nutrition, reduced stress, and familial support, a young person still might succumb to cultural pressures that lead him away from entrepreneurship. Attitudes about risk and failure are especially relevant. “When people laud the wonder of entrepreneurship as the solution to all kinds of problems around the world,” Sicina said, “they too often ignore that

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Homeland Success The building block of entrepreneurship is the power of ideas. In many developing nations, however, stress and poor nutrition inhibit cognitive development. Without peak performance, young people are less likely to engage in creativity—the spark of putting ideas together. “Those connections are fragile,” Edgell said. “It doesn’t take much for them to go away, or not be able to form at all.” An environment that puts stress on cognitive processing, therefore, may hinder the divergent thinking that leads to innovation. Edgell’s framework also draws on research into socioeconomic status. What’s interesting, he said, is that wealth is less of a predictor for creativity than how a family allocates resources. Budding entrepreneurs fare best when families recognize

their potential and support them, possibly with a disproportionate share of family resources. The notion of favoring one child over another gave Edgell pause. Yet he recognizes its pragmatic application: “If one kid had more access to funds, maybe he or she would be better able to take care of the family long-term.” Parents also shape children’s creativity when they engage in their own creative pursuits, expose children to diverse experiences, and express appreciation for creative expression. Research into the relationship between income and creativity also shows that many creative people emerge from a fertile economic middle ground, between the desperate struggle to survive and a too-comfortable existence that saps ambition. “Young people in those environments start to make a lot of things for themselves,” Edgell said. “This is not about glamorizing poverty; it’s just to say the lower-middle class may confer some incredible benefit when it comes to divergent thinking.” That divergent thinking, of course, is the hallmark of creativity. Fisher saw a similar dynamic in Tunisia, observing that residents of poorer areas were used to being self-starters. “Those people had been neglected for decades. The only way they could make money was by…enterprise.”

Homegrown Entrepreneurs

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there’s a lot of risk to entrepreneurship, and there’s a huge failure rate.” That’s equally true in the United States, with one key difference. In American start-ups, risk is par for the course. Their mantra might well be “Dust yourself off and start over.” Not so in Arabic and Muslim communities, Sicina said, where business failure can stigmatize individuals and families. “The risk of failure is so great as to be overwhelming against the potential rewards of success,” he said. “That, I think, is an important impediment to the growth of entrepreneurship.” Edgell points to the 10-year GLOBE study— Global Leadership and Organizational Behavior Effectiveness—that examined leadership attributes in 62 countries. Many developing nations, being collective and familial, may discourage novelty and innovation—the very traits entrepreneurship requires. In countries like China, Edgell said, cultural norms exert strong expectations on young people: “In the United States, we are a very individualist society, so we’re more accustomed to allowing some of that to flourish. But in those countries that are highly collectivist, that is sometimes not tolerated.” He cites research showing that differentiated, socially complex countries create a richer environment for divergent-thinking individuals to flourish. Educating families about the positive side of divergence could make them more hospitable to early entrepreneurial leanings, Edgell said. “If your kid is a little bit unusual, let’s understand why that is a good thing.” Pushing against norms may be an uphill battle, he added, but that is the road to change. Big-Picture Policies Government and other institutions comprise the outermost ring in Edgell’s framework. Korea, for

example, successfully used national incentives to boost its information technology sector. Initiatives in Korea’s Small and Medium Business Administration include financing, developing workers’ skills, and facilitating market access. According to a Bloomberg Businessweek report, the South Korean government spent $16.7 billion in 2011 to support small-to-midsize businesses. The investment paid off: between 2007 and 2011, the number of South Korean tech start-ups jumped 83 percent. “It’s worth noting, at the macro level, some of their policies seem to have been productive,” Edgell said. Government-funded mentoring and education programs, like Artists for Humanity and the National FFA Organization, formerly Future Farmers of America, also could be implemented. Such programs help stem the “brain drain” that often plagues developing countries, Edgell noted. “Intelligent or well-off kids leave and they don’t come back because they can’t deploy their skills there,” he said. Sicina believes government can create conditions that allow promising young entrepreneurs to be discovered. “You’ve got to sort and separate the wheat and the chaff; you’ve got to find the ones who are really determined and passionate; and you’ve got to nurture them by creating conditions for learning and coaching and mentoring.” Governments also can tailor education to the needs of business. Tunisia’s educational system, while free through the doctoral level, emphasizes science, engineering, and government jobs. As a result, Sicina said, the country has large numbers of well-educated, young people waiting for jobs that may not materialize. Finally, governments can deploy traditional economic tools, such as microfinance programs and national incentive strategies.

Tunisia, then, demonstrates that family, culture, educational systems, infrastructure, and government all coalesce to grow or stifle the next generation of entrepreneurs. Their best chance, Edgell’s framework suggests, lies in a comprehensive, wellintegrated strategy. “All these conditions have to be more or less aligned,” he said. Potential users of the framework include policy makers in developing nations, who could apply these concepts in communities. Officials could study thriving entrepreneurs to learn what path they followed and how it might be replicated, Edgell said. “See if there are young people who have been highly divergent and started their own businesses, and figure out what exactly their families did.” That dialogue, Edgell said, has the power to introduce new ideas that challenge existing norms. “You change the language, you change the rules, and you change the behavior.” Although top-down programs are crucial, Edgell pointed out that legislation does not necessarily change people’s minds. “You change things by going out and talking to people and introducing ideas,” he said. For Fisher, talking to people yielded insight into the complex web of factors that, for Tunisian entrepreneurs, build up conditions for success and threaten to tear them down. “A lot of people we met were really sharp,” he said. “I feel like, given the right resources, they could do amazing things.” “Developing nations and sustainable entrepreneurial policy: Growing into novelty, growing out of poverty” is forthcoming in the Journal of Applied Business Research in 2013.

TUNISIA: An Economy in Transition Criteria/Topic Rankings

2013 Rank

2012 +/- From Rank 2012 Rank

Starting a Business

-12

Dealing with construction permits

-6

Getting Electricity

-3

Registering Property

-6

Getting credit

104

-7

Protecting Investors

-3

Paying taxes

-2

Trading across borders

Enforcing contracts

-1

Resolving Solvency

-1

Source: The World Bank

Tune In to PLCY Radio Music lovers who enjoy Pandora Internet radio may wonder why they can only skip six songs in an hour and then must wait to skip again. For that matter, why can’t they pick a specific song to hear, rather than creating a channel based upon that song? And why can’t they hear more than four songs by their favorite artist in a three-hour period?

John Simson has enjoyed a career as a singer/songwriter, talent manager, and entertainment lawyer. He most recently served as Executive Director of SoundExchange, an organization he helped launch in 2001, and currently is president of the Washington, dc, chapter of the grammy organization.

KOGOD NOW FALL 2013 | kogodnow.com

Congress established these limitations and restrictions when it passed legislation in 1995 and 1998 that created the first digital performance rights laws in the United States. The legislation was a careful balancing act, with Congress attempting to weigh the rights of content creators—recording artists, record labels, songwriters, and music publishers—against those of an emerging category of content users: “webcasters” and satellite radio services. Included were new services, like Pandora, that sought to stream music across cable wires, from satellites, and over the Internet. For years, broadcast radio has streamed music to the public from radio towers without having to pay recording artists or record labels for the right to play their music. But radio stations did have to pay songwriters and music publishers through the three main licensing organizations that represent them: ASCAP, BMI, and SESAC. After passage of this historic legislation, services such as Sirius and XM satellite radio (now merged as SiriusXM), Yahoo! and AOL Internet radio, and later Pandora and other Internet radio stations, had to pay a royalty to the recording artist as well as the songwriter.

Background Music In the early 1990s, recording artists and their record labels lobbied Congress to pass a comprehensive performance rights bill that included traditional broadcast radio, known in the industry as terrestrial radio. But the terrestrial broadcast lobby was too strong, and so a compromise was reached: the old-guard terrestrial broadcasters would continue with their so-called “free pass,” but new services over cable, Internet, or satellite would have to pay. Thus, although singer Aretha Franklin would still

receive no payment from AM/FM broadcasters when they played “Natural Woman,” she would now receive payment from when it was played by Internet, satellite, and cable streaming services. As the songwriters, Carole King and Gerry Goffin would continue to receive payments from both the AM/FM broadcasters and these new services. The first issue that Congress had to address had nothing to do with the content users. It was a dispute between recording artists and record labels on the one hand and music publishers and songwriters on the other. The music publishers and songwriters were concerned that if this new law passed, one of two things might happen: 1. The record companies and recording artists would siphon off money that was currently being paid to songwriters and music publishers, who already had a right to be paid; or, more importantly, 2. Recording companies and recording artists could simply prevent the use of their recordings by saying no to the new digital services, thereby preventing the songwriters and music publishers from receiving any remuneration at all. Congress settled the second concern rather easily: the new right for record companies and recording artists was subject to a compulsory license. They had to license their recordings— they had no choice. That’s why Pandora and other services licensed under this congressionally mandated system can play any recording ever commercially released, while services such as

Spotify, which aren’t under this system, may be constrained from playing certain content.

KOGOD NOW FALL 2013 | kogodnow.com 17

Enter the ’Net Having settled the main bone of contention between the music publishers and songwriters and the recording artists and labels, Congress carved out a new compulsory license for webstreaming. Long before Napster and P2P services sprang up, the artists and labels wanted to ensure that their music wasn’t stolen over these new digital outlets. Restrictions were made part of the license. Even though a new online radio service could play any recording ever released, it could only play four songs in a three-hour period by the same artist, thus preventing the creation of “all-artist channels.” Online, there was enough available bandwidth to have as many channels as a service wanted to provide. If there were an all-Madonna channel or an all-Daft Punk channel, a listener could tune in to that channel any time they wanted to hear that artist, lessening the impulse to purchase that artist’s music (or so the logic went). So when you hear an all-artist channel, like Siriusly Frank or E Street Radio (both on SiriusXM), you know that the artist specially licenses it. In addition, the “playlist restriction” limited the playing of any more than two songs in a row by a particular artist (unless it was from a box set, in which case you could play three songs). John Lennon could only imagine how much time the lobbyists representing the content-owner side spent creating the language that became known as the “performance complement” in Section 114 of the US Copyright Act, which governs these playlist restrictions.

But their work was not without complications. I’m sure they simply weren’t thinking about classical music when they created the playlist restrictions and the definitions in the statute. By those definitions, it was impossible for a classical Internet radio service to play four movements in a row from the same symphony because each movement was deemed a separate track. Imagine if you had to play the first two movements from one version of Beethoven’s Fifth and then additional movements from a different version! Classical stations cried foul and needed help to resolve the issue. Section 114 of the Copyright Act does not specifically mention skips. Why, then, can a listener skip only six recordings in an hour? In the early days of Internet radio, the Recording Industry Association of America (RIAA), acting on behalf of content owners, took the position that any skips made a service “interactive” and thus ineligible for the congressional license. If they were interactive, like Spotify or Deezer, they’d need to get licenses from thousands of content owners and not simply take the statutory license given to them by Congress. But the RIAA entered into an agreement with a fledgling Internet radio service, and for a premium price allowed that service to offer their listeners the ability to skip up to six recordings per hour. Eventually, this became the de facto standard: six skips per hour were allowable within a noninteractive service. We don’t often think that congressional regulations and statutes actually have an impact on the music we hear, or the method by which we hear it, but that is certainly the case today for listeners of Sirius/XM, Pandora, and other non-interactive Internet broadcasters.

Five years ago this September, a series of events moved the financial markets to near-collapse. An Interview with Professor Robin L . Lumsdaine By david todd and jackie zajac

lehman collapse sends shockwaves around the world AIG bailout extended to $182 Billion washington mutual seized by feds

Lehman Brothers,

a major investment bank with more than $600 billion in assets, filed the biggest bankruptcy in history on September 15, 2008. Merrill Lynch was acquired by Bank of America, forestalling a similar fate. One of the world’s largest insurers, AIG, accepted an $85 billion emergency loan from the Federal Reserve to avoid bankruptcy. Professor Robin Lumsdaine joined the American University faculty as the Crown Prince of Bahrain Professor of International Finance just as the crisis was unfolding. An authority on international finance, Lumsdaine has extensive experience in academia as well as in the private and public sectors. A former

director at Deutsche Bank, Lumsdaine had earlier served on the President’s Council of Economic Advisers before returning to Washington to accept a position with the Board of Governors of the Federal Reserve System. As an officer in the division of banking supervision and regulation at the Fed and head of the newly formed Quantitative Risk Management group, much of her focus was on representing the Board in its work related to the Basel II capital regulations. “It was quite a first month as far as financial markets were concerned,” she recalled of her move to AU. “Fannie Mae, Freddie Mac, then Lehman, then AIG, then Washington Mutual. Overnight, interest rates spiked to 8 percent and there was no liquidity; the markets had seized up. Everyone was panicked.”

cover story the five-year mark

What began with disruption in US mortgage markets quickly spread. Some institutions were transformed to prevent failure; others failed outright. Each foundering firm was connected to a larger network of others, creating a ripple effect that threatened the entire system. Financial leaders and regulatory authorities moved aggressively to coordinate measures to address the breakdown. The US Congress passed emergency funding—the Trouble Assets Relief Program (TARP) in 2008 and the American Recovery and Reinvestment Act (ARRA) in 2009— to avert widespread collapse. Elsewhere around the globe, governments took extraordinary actions to stabilize their economies. In recognition of the five-year anniversary of these historic events, Kogod Now called on Lumsdaine to discuss regulation and issues of systemic risk in the banking sector.

KOGOD NOW FALL 2013 | kogodnow.com

KN: Systemic risk is a concept you’ve worked with for a number of years. Did it receive more attention among federal regulators once these events occurred? Looking back, how would you say the past five years affected our understanding of systemic risk?

Lumsdaine: I can’t discuss what specifically we talked about at the Fed, but certainly systemic risk was a topic of serious conversation even before 2008. For regulators, concern about systemic risk is comparable to the enterprise-wide risk management that regulators expect firms to practice. The regulators’ “enterprise” is the entire financial system, or the group of institutions they supervise. So mitigating systemic risk involves trying to ensure that the failure of a single institution, or group, won’t bring down the whole enterprise. Clearly this topic has gained more attention since those events.

Imagine a corporation with an array of managers, where each one focuses only on his or her piece of the business. How does the firm ensure that risk is managed across the portfolio of activities? Or consider an individual investor. It’s not enough for her to evaluate a stock individually; she needs to consider its role in the portfolio—whether it adds diversification, and the risk to the portfolio it if were to fail. Even as one manages the individual exposures, one should never lose sight of the big picture. Although regulatory focus has traditionally been on each individual institution, systemic risk involves looking beyond this and monitoring the institutions’ risks in relation to each other. KN: Is systemic risk primarily a regulatory concern? Lumsdaine: A key result of the Lehman Brothers collapse was that it altered the views of everybody, not just of the regulators. Suddenly, everybody came to appreciate how pervasive systemic risk is. I think there was always some recognition that firms were interconnected, but the Lehman bankruptcy really underscored just how interconnected they could be. In my view, systemic risk is everyone’s concern. KN: A recent Atlantic Monthly cover article stressed the continuing difficulty of determining the soundness of major banks. The authors wrote, “Banks today are bigger and more opaque than ever, and they continue to behave in many of the ways they did before the crash.” Do you agree with that? Have we already forgotten the lessons we learned in 2008? Lumsdaine: It’s not so much a question of what the lessons were or who we can blame; as I’ve said

before, perfect hindsight is just that. Reflection after a crisis is useful, provided we focus on what we do going forward. There is no question that some of the biggest banks are bigger today than they were pre-crisis, in part because of the consolidation that occurred in 2008. But many others are smaller, having seen dramatic balance-sheet reduction as a result of the crisis. It’s not as if a light bulb went on and suddenly people know all about how to identify systemic risk and manage it. There is a much clearer understanding that looking at firms in isolation is not sufficient to protect the financial system or economy. KN: How has the relationship of the investment banks to regulators changed? Lumsdaine: Post-Lehman, a number of the investment banks, for which the Securities and Exchange Commission had been the primary regulator, became bank holding companies, bringing them under the Fed’s supervision. Partly that occurred to give them access to the Fed’s lending facilities—essentially, to credit.

KN: We understand the banks undertook the shift to bank holding company status as a matter of crisis management. Lumsdaine: It wasn’t just the investment banks; a number of insurance companies and other firms also became bank holding companies during this time.

KN: Did it also constitute taking a step closer to a more diligent mitigation of systemic risk?

KOGOD NOW FALL 2013 | kogodnow.com

One of the difficulties investment banks like Bear Stearns and Lehman Brothers faced as the crisis unfolded was that they didn’t have such access.

cover story the five-year mark

Five years ago, in the fall of 2008, a series of economic breakdowns led to an intense period of rapid crisis and response. The following is a recap of key events that made headlines around the world.

SEP

XOM

September 17, 2008: To avoid bankruptcy, AIG, then one of the world’s largest insurance companies, was granted an initial loan from the Fed of $85 billion. That was eventually restructured and grew to $182 billion. Treasury Secretary Timothy Geithner later defended the measure as one needed to prevent economic catastrophe (January 27, 2010).

September 14, 2008: One of the nation’s largest investment banks, Merrill Lynch, was sold to the nation’s largest commercial bank, Bank of America.

MSFT September 7, 2008: The US government took control of Fannie Mae and Freddie Mac, the largest US mortgage-finance companies.

KOGOD NOW FALL 2013 | kogodnow.com 22

Lumsdaine: Certainly, bringing them into supervision by the Federal Reserve helps with systemic risk management, but I don’t think that’s why the firms did it. It’s hard to evaluate individual developments in isolation in terms of their contributions to systemic risk mitigation. There are other measures that have contributed as well. For example, the Dodd-Frank Wall Street Reform and Consumer Protection Act created the authority to designate an entity as a “systemically important financial institution” (SIFI). That brings the different regulators closer to consistency in how they approach systemic risk. It provides a way for uniform supervision and regulation of systemically important institutions. But it’s important also to consider the whole “shadow banking” sector, the other institutions that don’t fall under direct supervision at all. I’ve written about the SIFI designation in regard to MetLife. It was once the sixth-largest bank holding company, but it failed a government “stress test” [in March 2012]. In order to free itself from the oversight of the Fed, and the stringent capital regulations that a “systemically important” designation might entail, it exited the long-term care insurance business and deregistered as a bank holding company. While that may have made good business sense for the firm, the reduction of [regulatory] oversight may create more systemic risk, particularly as the long-term care insurance market becomes more concentrated with the exit of such a major player. Even though it is still regulated by insurance regulators, MetLife has now joined the ranks of the shadow banking sector.

September 15, 2008: Lehman Brothers, a major US investment bank, filed the largest bankruptcy in history, holding more than $630 billion in assets.

KN: Here’s a scenario: You take your car in for repairs, and the one thing is fixed but there are 20 other things wrong with it. The point being, how do we know that a measure taken to solve an immediate problem doesn’t create systemic problems down the line? Lumsdaine: At some level, we never know for sure. You would hope that the mechanic is looking at the totality of the system, not just the one part. Similarly, we need confidence that our regulators are trying to address the bigger picture and are very aware of unintended consequences. KN: Of measures taken these past five years, are any commonly agreed on as having significantly improved the system? Lumsdaine: I know of no one single thing everyone agrees was an improvement. No regulation is perfect. It was better to have something than not. We know that at least some of the regulatory response staved off greater trouble. Certainly when I think back to October 2008, in those two weeks after Lehman, I do think we were on the precipice and a number of the emergency measures helped, not only in preventing total collapse but also in the recovery. I would also argue that it’s perhaps still too early to tell. I remember similar discussions postEnron around the passage of the Sarbanes-Oxley Act of 2002 (SOX). There were a lot of concerns that regulators were going too far, that they were imposing significant regulatory burden and that

WMT

PFE

BAC

September 18, 2008: Lloyds, the United Kingdom’s largest provider of checking accounts, agreed to terms to purchase HBOS, Britain’s biggest mortgage lender.

October 3, 2008: The US government enacted emergency legislation implementing the Troubled Asset Relief Program (TARP), which authorized up to $700 billion to stabilize credit markets.

TM September 25, 2008: Washington Mutual was seized by federal regulators and sold to JPMorgan Chase in another of the biggest bank failures in US history.

DEC

WMT

September 21, 2008: The remaining two major investment banks in the US, Goldman Sachs and Morgan Stanley, also became commercial banks [bank holding companies] regulated by the Fed, in order to gain access to credit.

NOK

HBC

DEC

December 19, 2008: A loan of more than $20 billion of that funding was made to GM and Chrysler to avert the collapse of the US auto industry.

firms wouldn’t be able to conduct business. But a number of firms will tell you that their governance is much stronger now than it was before, that despite the pain of implementation, it was a good thing in hindsight. It is my hope that history will have a similar view toward some of the regulation that has occurred in response to the financial crisis. KN: On September 16, 2008, just one day after the Lehman collapse, the government stepped in to save AIG, ultimately lending more than $180 billion. Apparently this worked; the government’s been steadily reducing its position in AIG. Could that rescue be considered an illustration of how to manage systemic risk?

KN: To that end, let’s look at the eurozone, at relationships between our regulation and theirs. Have we shared any lessons back and forth across the Atlantic that point to greater management of systemic risk?

KOGOD NOW FALL 2013 | kogodnow.com

Lumsdaine: There’s a delicate balance between being proactive and reactive. In general, the key to risk management is being proactive and making sure one has systems and processes in place to identify and mitigate a problem before it occurs. At the time, some argued the government’s action was just reactive. But in the ensuing five years it’s been very focused on being proactive, trying to make sure the system can weather future challenges.

cover story the five-year mark

senator chris dodd

REP. barney frank

KOGOD NOW FALL 2013 | kogodnow.com

Lumsdaine: There has always been coordination between regulators in different countries, but there is certainly more as a result of the crisis. It is enormously challenging to come up with global regulations that will work for every national jurisdiction because the underlying regulations have to be consistent with each country’s individual accounting, legal, tax, and supervisory structures. I think an effect of the 2008 experience has been an increased emphasis on transparency— sharing information, working together to address matters regarding any particular firm—as well as the recognition that there is no single designation of “systemic risk.” For example, consider the presence of a major bank, say Citigroup, in various countries. The primary regulator of Citigroup, the parent company, is in the US. But Citigroup has subsidiaries all over the world. And while a single subsidiary in a small country may not represent a large risk to the firm— and thus might not be systemically important from the US regulator’s perspective—for that country, it may be the biggest bank and thus incredibly systemically important.

KN: Then the more international coordination that happens, won’t the challenges of identifying systemic risk become more difficult?

Even with domestic regulations such as with Dodd-Frank, many have expressed a frustration that, three years after its passage, a number of the specifics needed to implement it still haven’t been determined. Lumsdaine: It is incredibly challenging. And of course, the devil’s in the details. If there is one thing that should be emphasized, it’s this: If Lehman was a defining moment, as many people believe, then we also should appreciate how, for regulators, there’s not only more scrutiny but also more pressure. It is enormously challenging to craft regulation. Dodd-Frank alone called for more than 400 additional regulations. Basel II took more than a decade. That was something I learned at the [President’s] Council [of Economic Advisers]—about the challenges you face when actually making policy. I remember realizing that when we sit on the outside and hear about some new policy, it’s easy to wonder how the government could come up with something so complicated and imperfect. But when I was on the inside, at the negotiating table, I saw that often the rules come out this way because everybody is working very hard to come up with a compromise that meets all the different needs of everybody in the room, all the

constituents. And it’s virtually impossible to come up with something that will. This challenge is especially great when you’re dealing with capital regulations, where one needs to reconcile the rules and definitions with accounting, tax, and legal standards in each country. And postcrisis, some of that work has gotten even harder amid this sense now that the stakes are higher. KN: This brings us back to the question of systemic risk, doesn’t it? Take Cyprus. So many ordinary observers were astonished to learn that when this relatively small nation’s banking system was at risk, all the eurozone was at risk. Its population is 1.1 million. The eurozone calculated that it would need $30 billion. That’s approximately $30,000 per person! Lumsdaine: Have you ever divided the US debt by the US population? Thirty thousand is far less than $16 trillion spread among 300 million people. KN: How should we have known that risk in Cyprus could relate to, for example, risk in Brazil?

KN: Is anything more critical than understanding these linkages—or is that just impossible? Lumsdaine: To understand the networks is challenging, but incredibly important. I don’t think it’s impossible. Post-Lehman, I think that people understand the significance more. Whether it’s banking networks or country networks, it’s the same concern. You asked how Cyprus could matter so much, given its relatively small size. It is one of Greece’s biggest counterparties—and Greece, of course, is connected to every other country in the eurozone. Suddenly all the eurozone is connected to what happens in Cyprus. One seemingly little thing can upset a whole cycle or cascade into other events, and suddenly it becomes a systemic issue. KN: What happened with Cyprus? To the casual observer, it seemed to come out of nowhere.

Lumsdaine: Cyprus was disastrous in how it was handled. An adage in risk management is that it’s the thing you’re not paying attention to that can kill you. When you know where 99.9 percent of the risks come from, you aim your resources at identifying and mitigating that. What’s in your blind spot, in the one-tenth of one percent area, is what escalates to something fatal. In the US, we’ve got about 7,000 banks, down from 8,000 or so pre-crisis. Yes, the top 50 represent a large proportion of the overall banking assets, but still: we have quite a few banks. In Cyprus, when the No. 2 bank got into trouble, that represented nearly half the country’s banking assets. The hint that the deposits might not be safe threatened to undermine the entire Cypriot banking system. And once it became clear that this meant

KOGOD NOW FALL 2013 | kogodnow.com

Lumsdaine: Again, this is where the difference comes up between the perception of folks who follow these things on a day-to-day basis and the perceptions that are, understandably, held by much of the rest of the world. Back in 1999–2000, there was contagion between Brazil and Russia [which had devalued the ruble, defaulted on domestic debt, and declared a moratorium on payment to foreign creditors]; when the Brazilian currency absolutely collapsed, people were just amazed that those two currencies even had anything to do with each other. These connections surface repeatedly. In some ways, what can be the most difficult challenge with systemic risk, spillovers, or contagion is identifying the linkages. For example, most firms have a pretty good idea of who their counterparties are, right? By “counterparties,” we mean the people they do business with. But how much do they know about their counterparties’ counterparties, or those counterparties’ counterparties? But those linkages matter. That was part of the issue in 2008 with Lehman Brothers. It was everybody’s counterparty. So, say you’re a bank with 10,000 clients in all

lines of business. Thus each individual client represents a tiny part of your business, and in that sense you’re pretty well diversified. Many firms are in that position. But then suppose significant portions of those clients also are doing business with another firm, which then collapses. Suddenly not just one entity is collapsing but many are. When we think about systemic risk, we’re trying to understand such linkages. Some of the recent research I’ve been doing relates to these kinds of networks.

cover story the five-year mark

AIG freddie mac six degrees of

general motors

bank of america

merrill lynch

BROTHERS barclays

goldman sachs morgan stanley

the eurozone deposit insurance guarantee might not be honored, the possibility of Europe-wide bank runs emerged. Officials from other European countries were quick to distance themselves from Cyprus’s decision—but for a few days, we were on the brink once again. Cyprus actually reminds us that even a single country in the eurozone can pose systemic risk. We’re globally connected. And there are plenty of other examples—the Southeast Asia crisis in 1997 and Iceland, to name just a few recent ones. KOGOD NOW FALL 2013 | kogodnow.com

KN: Looking ahead to the next five years, what are some of the future risks that you are worried about?

Lumsdaine: Let me highlight two issues I’ve focused on for much of my career. The first is the importance of data collection and IT systems at the biggest financial institutions. Before the crisis, we experienced a long period of benign economic conditions that facilitated tremendous growth in the banking sector, mostly through mergers and acquisitions. In the aftermath of the crisis was another round of consolidation, for different reasons. A result of such consolidation is the enormous IT effort that is

involved when firms with different servers suddenly have to talk to each other. There is often a struggle to get systems up and running quickly post-consolidation. Because IT is a cost center, not a revenue center, it typically does not get as much budget allocation as it needs. Consequently, the work of harmonizing these systems post-merger occurs in a patchwork fashion. The costs of this were evident in the fall of 2008: firms were scrambling to identify and value their exposures post-Lehman. If the firm doesn’t know its own exposures, the regulator won’t, either. I’ve often said, “Don’t wait until you need the data to collect the data.” This is true for both firms and regulators. Good data collection is critical to any advance warning system and should be an essential part of a firm’s risk management. The second major concern is the changing demographic landscape, which I believe is one of the biggest risks facing global financial stability today. We’ve all heard about health-care costs rising faster than the rate of overall inflation, the large proportion of uninsured, and the rising costs of social security. But there has been little attention given to the interaction between health-care regulation and banking regulation. And yet much of the discussion in addressing countries’ financial challenges has centered on the need to reform pension benefits. We’ve already discussed MetLife’s exit from the long-term care insurance industry in response to capital regulations, despite projected increases in demand for the product. Also, the funding gap for state pensions as a percentage of GDP is steadily rising. And private companies are discovering that their retiree health obligations are not sustainable. These are just a few reasons why demographics and health-care considerations are becoming an increasingly important aspect of global financial stability. Yet for the most part, health-care regulation and financial regulation develop separately from one another, resulting in unintended outcomes.

Business Bribes: Who Pays Them, and Why? Publicly traded companies and firms based in countries that have adopted anti-corruption practices are somewhat less likely to engage in bribery. That’s according to new research by Assistant Professor Yujin Jeong, whose findings shed light on a subject that is not well understood and underscores the value of anti-corruption policies and regulations.

Jeong was drawn to the topic of bribery because it is fairly common in international business but not well documented. Although it is easy enough to grasp why one party demands an illicit payment, Jeong sought to understand more about the supply side of the equation: why do businesses pay bribes, or decline to do so?

Regulatory Framework Cross-border bribery has long been illegal in the United States through the Foreign Corrupt Practices Act of 1977. In 1999, the Organization for Economic Cooperation and Development (OECD) adopted the Anti-Bribery Convention; as of May 2013, 40 countries were on board. Some nonOECD countries, however, have no explicit ban on bribery. Although some companies based in countries covered by the convention did indeed pay bribes, they were somewhat less likely to do so. These findings “provide optimism for anti-corruption efforts by the international community” having a deterrence effect, according to Jeong. While these findings have provided some groundbreaking empirical research and earned Jeong significant recognition, they come with one big caveat: money talks. The financial incentives involved in paying bribes are a key motivator for private-sector bribery, and one that often overrides the company’s public disclosure requirements or its home-country rule of law. Different companies may be more or less likely to engage in bribery, but in the end, bribery is widespread across many business sectors. Regulations may reduce the prevalence of bribery, but—at least in this case—they did not eliminate it. For that reason, Jeong recommends a more refined policy approach that is focused at the company level. “Private companies often circumvent the [antibribery] convention,” she explained. “We should work to improve corporate governance at the local level and strengthen monitoring and legal enforcement at the international level.”

“Who Bribes? Evidence from the United Nations’ Oil-for-Food Program,” with Robert J. Weiner, was published in Strategic Management Journal in 2012.

Article By Andrea Orr

KOGOD NOW FALL 2013 | kogodnow.com

Not Data-Driven Corruption is one of the more mysterious aspects of business. In a discipline known for being datadriven, it is difficult to account for all of the players who skirt the rules. And while people often make assumptions about bribes and business, there is little data on actual bribes. “Nobody wants to reveal whether they paid a bribe, not to mention how much they paid,” Jeong explained. She found one significant exception to this in the United Nations’ Oil-for-Food Program (1996–2003). The program aimed to alleviate Iraqis’ suffering caused by the UN sanctions imposed on Iraqi oil exports. Starting in 2000, the Iraqi government exploited the system and collected $229 million in illicit surcharges from its oil buyers. An official investigation yielded unprecedented amounts of data on bribery: some 187 companies from 51 different countries participated in the program, and most paid bribes. Jeong’s study, co-authored by Professor Robert J. Weiner of George Washington University, examined what influences a firm’s decision to pay a bribe in an environment of “pay to play,” where bribery is likely to bring high rewards but also presents high risks. How would companies from around the world respond differently facing the same requests for bribes? What would explain the variability in the amount of bribes paid by firms in international business? The researchers found that businesses’ ownership structure was a significant factor. Owners and managers in privately held firms that were less subject to public scrutiny were more likely to pay bribes. The perception that a certain country was predisposed toward corruption turned out not to be a strong indicator.

“Many people tend to think that companies from less-developed countries may be more prone to corruption,” said Jeong. Her research, however, showed no significant correlation between “perceived corruption” and actual corruption.

Why Emerging Economies Should Welcome Foreign Banks Direct investment in a country by foreign banks can stir debate. It gives rise to questions about the ways in which banks’ involvement may be either disruptive or beneficial to the host country’s banks, to its industries that rely on external financing, to the legal structures and flow of information, and to the economic development of the country.

Article By David Todd

Associate Professor Robert Hauswald and Assistant Professor Valentina Bruno recently published important findings that shed light on the true effects of foreign banks. In their research, they summarized the debate: On the one hand, foreign banks can supply additional funds for loans, and may have an advantage in overcoming formal obstacles to lending—two benefits to real economic activity. On the other hand, some observers fear that, as foreign banks make inroads into a country’s business landscape, the effect on domestic banks might be to “compete them out of the water,” according to Hauswald. The fear is that these foreign banks dry up the overall pool of credit available to firms and to the country’s economic development.

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The Reality Until now, no research on foreign banks’ local lending has taken such a global approach, or undertaken the same level of thorough analysis to isolate specific economic mechanisms at play. The authors’ surprising finding: Local lending activities by foreign banks consistently and significantly improve growth prospects in emerging economies. “In one of the robustness tests we applied,” Hauswald said, “we didn’t simply parse the effect between advanced and developing economies. We looked at the effect on high-, medium-, and lowincome countries. “What you see is that it’s the ‘medium-income,’ emerging economies that drive the effect—such as Malaysia, Indonesia, Mexico, Chile, South Africa, and so forth.”

External Financing Their analysis factors in the significance of unique economic sectors, particularly industries such as manufacturing, which depend more on external financing for their operations. Data on 36 types of manufacturing industries entered the calculations. Such industries are important contributors to economic activity and represent a useful benchmark. Consider steel manufacturers. These firms “operate at a certain scale, where there is a combination of

both thin profit margins and large capital expenditures involved in production,” Hauswald explained. “So they rely much more on external financing than, say, high-technology firms, many of which do not depend as heavily on plants and equipment, and so require less capital expenditure to operate,” he continued. They thus need fewer resources in terms of external credit. “The greater an industry’s dependence on external finance,” the authors wrote, “the more the presence [of foreign banks] furthers real economic activity, especially in developing economies, where information and legal frictions [otherwise] often hinder access to credit.” That finding, Hauswald said, is what has drawn especially wide attention to this study. “We identified two new mechanisms—until now overlooked in the literature—by which foreign banks spur real growth.” The banks’ beneficial effect appears most prominently in emerging countries where information-sharing mechanisms and the rule of law are not fully established. In fact, the benefit is most pronounced in places where these two essential components of a nation’s economic infrastructure are still being created. In such countries, Hauswald said, foreign banks seem to improve the efficiency of information sharing in the local banking market. Local banks and clients start providing each other the needed financial information more quickly and easily to overcome obstacles to lending. Moreover, in countries where the legal systems aren’t developed enough to ensure that contracts will be enforced and deals run smoothly, new business practices from foreign banks can keep such legal deficiencies from getting in the way of successful lending. Greater Access The study also found that foreign banks’ ability to respond constructively during local banking crises illustrates how they’re able to wield a positive economic effect in the face of inadequate legal protections. Through their parent firms, foreign banks often have better access to capital than local lenders.

This means foreign banks can continue to lend even when local institutions won’t. As a result, borrowers who anticipate a future credit need may be reluctant to default on loans to foreign banks, even when the host country’s capacity for legal enforcement is weak. The more stable lending competence, the authors noted, gives foreign banks “greater clout” with borrowers, which can aid in the enforcement of debt contracts and thus can “substitute for insufficient legal infrastructure.” Similarly, foreign banks can also substitute for information-sharing mechanisms in emerging markets. Their role in overcoming informational inefficiencies appears where the bank enters the economy not by launching its own operations through “greenfield investments,” such as establishing a new branch, but by acquiring an existing bank. Typically, Hauswald and Bruno wrote, foreign banks possess a credit-assessment expertise that includes credit scoring, automated monitoring, and other technologies, all of which are often “deemed superior to domestic operating policies, especially in emerging economies.” Since local banks generally hold an “informational advantage,” the authors observed, “acquiring domestic banking assets allows entrants to combine their own credit-assessment expertise with access to local data and borrower-specific information.” “Intuitively, this makes sense,” said Bruno. “By acquiring an existing local institution, the bank acquires clients, credit histories, records of past investments. This is particularly important in countries where a credit history is not easily available through a simple credit-score search.” The professors concluded that “foreign banks can overcome informational obstacles to lending through acquiring existing banks in-country, especially in informationally opaque emerging countries.”

Emerging vs. Advanced Having teased out the markers of “pure” foreign bank effect to ensure reliable, independent analysis, and then compared the results in both advanced and emerging economies, Hauswald and Braun discovered an intriguing symmetry. In emerging economies, foreign banks wielded their positive economic effects independent of variations in the institutional infrastructures (such as legal protections, credit reporting agencies) of the host country. But in advanced economies, the opposite held. Foreign banks exhibited no statistically significant effect on economic growth in those countries, but the varying qualities of those countries’ institutional infrastructures—“in the trappings of modern financial markets”—did show a such an effect. “Our interpretation,” Hauswald said, “is that in emerging economies, the activities of foreign banks do act as substitutes for a lot of the institutional underpinnings of modern credit markets. But in advanced economies, they have nothing to add, at least in terms of information production or enforcement mechanisms.” Hauswald and Bruno concluded by noting several policy implications. Chief among these was emphasizing to policy makers that once a developing economy has attained a certain level of “institutional maturity,” foreign banks stimulate real economic activity rather than destabilize the economy—and in fact can provide continuity during times of crisis. “The Real Effect of Foreign Banks,” Robert Hauswald and Valentina Bruno, is under revision for resubmission to the Review of Finance.

ABOUT THE STUDY Their decision to conduct a broad, cross-country analysis was fundamental to Hauswald and Bruno’s research, which they began in 2006 when Bruno was an economist and Hauswald was a visiting scholar at the World Bank. They drew upon two main sources of data: the UN Industrial Statistics and the World Bank’s data on foreign banks. Countries with less than 10 industry-year observations—Algeria, Swaziland, and Uganda—were excluded from the research, as were six countries with insufficient balance-sheet data (Barbados, Finland, Greece, Italy, Jamaica, and Macedonia). The United States also was excluded to avoid statistical errors. With a time frame that ensured a representative sample, they analyzed data from more than 3,000 financial institutions operating in 22 advanced and 59 developing countries.

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A Rising Tide… Importantly, the researchers found no evidence that local lending by foreign banks supplants domestic banks.

Rather, they concluded, since foreign banks’ entry leads to the relaxation of constraints against overall growth and affects emerging markets positively, local banks benefit as all sectors of the economy improve. Indeed, as Hauswald observed, foreign entry serves to stimulate the local banking sector to greater efficiency. “Competition does good things for you,” he said. “We forget that sometimes.”

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More than a decade ago, the New York Times kick-started an examination of the business practices of Computer Associates International, Inc., a global software company with a market value of $20 billion more than Nike or Lockheed Martin. The formal investigation that followed the 2001 Times story consumed the US Attorneysâ&#x20AC;&#x2122; Office, the FBI, and the Securities and Exchange Commission.

KOGOD NOW FALL 2013 | kogodnow.com

Article By David Todd

When the sec comes calling

For a time, Computer Associates executives obstructed the government’s investigation. They withheld documents and made false statements. They covered up. But what eventually unraveled was a deception that made national headlines. For more than two years, Computer Associates had inflated its quarterly earnings reports by recognizing revenue from software contracts that hadn’t been executed. The executives accomplished the fraud partly by extending fiscal quarters to recognize additional revenue prematurely, a technique they called “the 35-day month.” For one quarter in 2000, they opted not to apply the technique—and failed to meet earnings estimates. On the first business day after the quarter close, Computer Associates’ stock price plummeted 43 percent. Ultimately, the company was forced to restate $2.2 billion in sales as a result of this misrepresentation. A committee later appointed by the board of directors described it as “a massive accounting fraud perpetrated by the company’s senior-most executives.”

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LAW & ORDER Given the ensuing multi-year period of concealment (and eventual disclosure) of charges filed and agreements made, a casual observer might not appreciate the lengths that regulators went to in order to enforce the law. Instead, the case may seem like one more justification for the commonplace opinion that, as Associate Professor Gerald Martin has put it, “executives who cook the books end up getting just a slap on the wrist.” Martin himself once was prone to this view. Before he started researching the data on enforcement actions against financial misrepresentation, he recalled, “I hadn’t yet really questioned this somewhat popular notion that penalties are often a bit slight relative to the conduct involved.” But in the 1990s, shortly after becoming CEO of an aviation financial services company, Martin discovered that one of the partners to whom he reported was attempting to cheat another. Fortunately, the harm was discovered in time to be rectified, but the experience left its mark.

Regulators cannot optimally enforce laws against misconduct without some element of corporate self-reporting and cooperation. No longer was financial misrepresentation something Martin had only heard about; now he’d actually witnessed it. Years later, he began to gather comprehensive data on the phenomenon. He has since published and presented findings on the legal penalties for financial misrepresentation and the cost to firms of cooking the books. Now, in collaboration with Rebecca Files of the University of Texas at Dallas and Stephanie Rasmussen of the University of Texas at Arlington, Martin has written a comprehensive article on the monetary benefit of cooperation in regulatory action. Teamwork? “Regulators cannot optimally enforce laws against misconduct without some element of corporate self-reporting and cooperation,” the authors wrote. Although the general importance of cooperation has long been known, regulators haven’t always emphasized it as a tool of enforcement per se. Martin noted that the SEC first publicly acknowledged the benefits of cooperation to enforcement in an October 2001 release: Our willingness to credit such behavior in deciding whether and how to take enforcement action benefits investors as well as our enforcement program. When businesses seek out, self-report and rectify illegal conduct, and otherwise cooperate with Commission staff, large expenditures of government and shareholder resources can be avoided and investors can benefit more promptly. Currently, the SEC and the Department of Justice follow principles stated in pertinent manuals and sentencing guidelines to credit cooperation in enforcement actions. However, “of necessity, they’re general guide-

lines,” Martin said. “Some members of chambers of commerce, for example, would love it if you could quantify for them exactly what sorts of cooperation correlate to particular credit” against the ultimate costs that otherwise might be imposed. Of course, since no two cases are identical, such detail isn’t possible. Even if it were, “regulators wouldn’t want to specify it since that would deprive them of bargaining power.” Although regulators do make public statements in their proceedings, Martin said, “to indicate that cooperation influenced...monetary penalties,” the lack of detailed analysis of that influence has prompted some corporate managers to question whether the benefits of providing cooperation are, in fact, worthwhile. And so, the researchers concluded, industry professionals have been skeptical about precisely how much cooperation firms should extend to regulators.

Show of Mercy In an analysis that laid the groundwork for the study, Files sampled 127 instances wherein the SEC exercised leniency in enforcement actions involving companies that restated earnings. This more limited inquiry showed that cooperation in such cases was associated with a somewhat higher chance of being sanctioned by the SEC at all, and with a lesser monetary penalty. Still, it remained for the professors to address the larger, more comprehensive question: What features are common to firms that cooperate, and under what sorts of circumstances do they do so? If—as the regulators’ public statements of crediting would suggest—cooperation actually reduces the ultimate financial loss to a firm, then just how much money do you save, on average? For context, the authors noted, “[T]he average firm sanctioned by the SEC or DOJ for financial

Key findings Likelihood that a firm will be named a respondent in an enforcement action if it cooperates with regulators, up from 78% for noncooperative firms Reduction in monetary penalty for a firm that cooperates with investigators

Increase in a noncooperative firm’s monetary penalty, translating into a $6 million benefit for cooperating Reduction in monetary penalties when a company undertakes independent internal investigations, averaging $8.2 million in lower penalties Firms that cooperated with regulators when facing enforcement actions from 1978 to 1989 Firms that cooperated with regulators when facing enforcement actions from 2000 to 2011

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89% 34.7% 53.1% 47.1% 3.1% 42%

“This research turned me 180 degrees from the idea that the penalties were lenient.” gerald martin, associate professor

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misrepresentation pays nearly $17.3 million in fines and penalties to regulators.” To obtain a thorough enough sampling, the authors analyzed SEC- and DOJ-initiated enforcement actions for financial misrepresentation from 1978 through 2011. So that their valuation of “monetary benefit” would include measurements relating to common stock prices, they limited their sample to the 1,059 enforcement actions involving firms with common equity securities.

THANK YOU FOR YOUR COOPERATION? It’s clear that regulators heed published guides in deciding on an enforcement action against a particular firm. In the authors’ analysis of actions over the 33-year period they studied, they controlled for those criteria—including the nature and extent of the violation, firm characteristics, and the regulatory environment. Consistent with prior studies, the research found

that cooperating with regulators increases the likelihood—by more than 11 percent—that a firm will be named as a respondent in an enforcement action. Since the likelihood of such an action is already high—nearly 78 percent, regardless of cooperation—this increase is relatively minor. There also are significant monetary benefits for firms that cooperate with regulators: “Being cited for cooperation by regulators in a[n]… action reduces the firm’s monetary penalty by 34.7 percent.” Conversely, being uncooperative increases the penalty by 53.1 percent. Assuming an average penalty, cooperation translates into a $6 million benefit. And for companies that conduct independent internal investigations and provide the results to regulators “unconditionally,” monetary penalties to drop by 47.1 percent—an average “savings” of $8.2 million. “We find that monetary penalties are highly systematic and significantly associated with many criteria considered by regulators, including the direct benefit to the firm, shareholder harm, characteristics of the misconduct, and remedial efforts,” the authors wrote. Their analysis also produced ancillary findings. For example, firms that are more likely to cooperate tend to have certain things in common, such as a lower relative market valuation (as measured by the market-to-book ratio). The financial misrepresentation of these firms usually centers on foreign bribery charges, is associated with inadequate internal controls, or is motivated by internal or external sales or earnings expectations. Moreover, the misconduct does not involve fraud, and the firm responds quickly once leaders become aware of it. Firms were generally also penalized more when the violation period was longer—thus creating more chance for shareholders to be harmed. In fact, where underlying violations caused harm to shareholders, the typical investor loss was substantially lower for cooperative firms—55.8 percent—contrasted with approximately 70 percent for uncooperative firms. Looking Up The authors also found an impressive overall trend: enforcement actions and cooperation both have increased markedly. The number of annual enforcement actions for financial misrepresentation has grown, from an average of 13.5 per year during the period

Growth in enforcement actions Time frame Average Enforcement Actions Per Year

% Increase

1978–1989 13.5

n/a

1990–1999 30

+55%

2000–2011 49.8

+39.8%

1978–1989, to 30 per year during 1990–1999, to 49.8 per year during 2000–2011. The proportion of enforcement actions citing firm cooperation also grew—from just 3.1 percent in 1978–1989 to 42 percent in 2000–2011. “The dramatic rise in credit given in the last decade,” the researchers observed, “may be due to either an increase in cooperation, an increase in regulators’ willingness to credit, or both.”

"The Monetary Benefit of Cooperation in Regulatory Enforcement Actions for Financial Misrepresentation," Rebecca Files, Gerald S. Martin, and Stephanie J. Rasmussen, was published in 2012.

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A New Perspective “This research turned me 180 degrees from the idea that the penalties were lenient,” Martin recalled. “Clearly, the SEC and the other agencies are finding ways to proportionately reward cooperation.” Mere observation without in-depth analysis, he pointed out, would likely miss this fact because these enforcement actions take a long time to complete. “The average length of time from when a violation begins—when illegal activity first started to occur—to the very end, the last regulatory action, is eight years.” Studying the data, he said, “you can see how firms that cooperate want to ferret out the harm. They get just as mad as shareholders do when a rogue executive or staffer has been violating the law, and they want to do the right thing. “But you’re talking about a long, long time frame.” The enforcement action against Computer Associates, he said, pointedly illustrates both sides of this dynamic. The company’s initial failure to cooperate constituted, as the US Attorneys’ Office put it, “the most brazen and most comprehensive obstruction that we’ve witnessed in recent history.” But about two and a half years after federal investigations began, in mid-2004, the company

accepted responsibility for its conduct, according to the SEC. Acknowledging that, as a result of the conduct of certain executives and other employees, it had made false statements and obstructed investigations, Computer Associates reached a settlement agreement with the government in September 2004. The company agreed to pay $225 million in restitution, fire the offending officers and employees, change its management, and accept independent monitoring to ensure future compliance. The US Attorneys’ Office agreed to defer prosecution, citing the company’s “continued cooperation.” By the time enforcement actions concluded in 2007, eight executives had pleaded guilty to charges of federal securities fraud and/or obstruction of justice. For seven of them, the penalties amounted altogether to about $80 million; four were sentenced to prison terms. But of these seven executives, the SEC said in a public announcement, five also agreed “to cooperate with the prosecution.”

Congressâ&#x20AC;&#x2122;S Failing foresight As the world economy grows, financial regulation becomes an increasingly difficult subject to broach, much less realize. There is no easy answer to the problem; what we know is that a global solution is needed. The Basel Accords have attempted to bring consistency to the transnational financial sector, but the inability to enforce these regulatory recommendations arguably limits their potential. The G-20 major economies that participate in the Basel Accords are free to interpretâ&#x20AC;&#x201D;and adoptâ&#x20AC;&#x201D;them at their leisure. The most recent accords, Basel III, were proposed in 2011, but projected implementation was pushed back to 2019.

This has come to represent a common theme for such regulation. Inconsistency has plagued the regulatory environment, but perhaps the larger issue is its slow and reactionary nature. Domestic regulators need to identify and close the loopholes to create a global regulatory standard. For financial regulation to be effective over the next several decades, it needs to both span borders and anticipate potential market risks more effectively. These images illustrate the growth in financial regulation in the United States after economic crises, and the deregulation that often preceded them. Significant pieces of legislation have been highlighted to show political party breakdowns in the House and Senate.

Financial regulations PASSED Legislation passed per decade

8 5

1930s

1940s

1950s

1980s

1990s

1960s

1970s

2000s+

reguLatION/ DEREGULATION regulation deregulation

-1

-8

-6

1980s

1990s

-5

-10 1930s

1940s

1950s

1960s

1970s

categories affected 1 2 3+

Methodology: Each act is assigned a value of -3 to 3 based on regulation or deregulation. “Categories” are defined as different financial sectors. Values are assigned as followed:

Significant fiscal policy requires and has historically resulted in a bipartisan effort. Sweeping regulation or deregulation has overridden party lines when necessity and the economic environment have trumped political differences—that is, until the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. Dodd-Frank exemplifies the growing divisiveness of the US’s political party system, which limits the

2000s+

Regulatory Deregulatory 1 -1 2 -2 3 -3

ability to recover from the most devastating financial crisis since the Great Depression. Allegiance to one’s party has perhaps replaced achieving beneficial resolutions; regulatory progress has stalled. In the 15 years since passage of the Gramm-Leach-Bliley Act (also known as the Financial Services Modernization Act of 1999), there has been a noticeable shift from bipartisan efforts to voting along party lines for major financial legislation.— Max Chilkov

The Vote:

HOW THE US SENATE VOTED on major regulatory legislation YES

GRAMM-LEACH-BLILEY

92 %

8 %

SARBANES-OXLEY

100 %

DODD-FRANK

0 %

1999

61 %

39 % 2010

SARBANES-OXLEY

DODD-FRANK

Party Lines:

Party affiliation for each bill DEMOCRATS

REPUBLICANS

INDEPENDENTS

GRAMM-LEACH-BLILEY

45 % 55

49 %

40 % 51

58 %

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2002

The Business of Government Consulting “Geographically, DC might be small, but in terms of consulting, it’s huge,” according to Drew Deogracias, MA/MBA ’10. Washington, DC's high concentration of consulting firms, particularly those that specialize in federal practice, is what attracted Deogracias, a consultant at Deloitte, to the area.

Article By Laura Herring

“I knew I wanted to work [in federal consulting], so when the opportunity to come [to DC] came up, I seized it,” he said. Twenty years ago, federal consulting didn’t exist as an industry, at least not on a large scale. Today, it’s a multibillion-dollar field, with firms—big and small—vying for high-dollar projects from government agencies and departments. In 2012 alone, more than $500 billion in federal dollars was awarded in contracts to hundreds of companies, most in the DC region.

KOGOD NOW FALL 2013 | kogodnow.com 38

Birth of an Industry The number of companies entering the consulting field has grown exponentially in recent years, in large part because regulations limiting the services one firm can provide have been lifted. The expansion of the large accounting firms Deloitte, KPMG, EY (formerly Ernst & Young), and PricewaterhouseCoopers into consulting is a prime example. When Congress passed the Financial Services Modernization Act of 1999, known as the GrammLeach-Bliley Act, many of the regulations that had limited large firms’ reach since the stock market crash of 1929 and the Great Depression were stripped away. For the first time in decades, large professional services corporations were now free to acquire smaller, more narrowly focused companies and expand their business. “Firms that used to be incredibly specialized, like the big accounting firms, [could] broaden their practice base because those regulations weren’t there to prevent them from branching out,” said Associate Professor Mark Clark, an expert in human capital management. “They moved far beyond just bookkeeping.” One firm could now provide any combination of insurance coverage, investment banking advice, and commercial banking services, among other resources, to the same client. PricewaterhouseCoo-

pers alone now had specific departments for audits, risk assurance, tax accounting, and consulting services, for both the private and public sectors. “Now these large firms, who [had] gotten to know their client agencies very well over the years, [were] free to tap into that knowledge and offer more,” said Clark. But reducing regulations around client service offerings didn’t reduce outside scrutiny. The Big Four were still subject to close study for any signs that they might be violating conflict of interest by offering investment advice and auditing services to the same client. During the years surrounding the turn of the century, the consulting branches of these firms grew rapidly. But as the Securities and Exchange Commission voiced mounting concern, especially after the Enron scandal, most firms slammed on the brakes. After nearly a decade of lucrative expansions into professional consulting coupled with financial auditing work, the Big Four began divesting their consulting practices. By the end of the decade, only Deloitte remained deeply entrenched in the consulting business. Other firms, such as Lockheed Martin, CSC, and Booz Allen Hamilton, reaped the benefits, picking up big contracts in defense and technology. Working for The Man By focusing on federal clients, consulting practices face fewer concerns about conflicts of interest while still winning high-dollar contracts. Lockheed Martin, based in Bethesda, Maryland, earned nearly $37 billion in federal contracts in 2012, more than any other company. According to the US Bureau of Labor Statistics, the umbrella industry “Management Analysis,” which includes government consulting, is projected to grow 22 percent by 2020, much faster than the 14 percent average of all other industries tracked.

To Clark, this projection is conservative. “As more and more firms and agencies realize it’s a better use of their resources to hire itinerant consultants to oversee the regulatory components of bigger projects than to build expertise internally, we’re going to see an even bigger need.”

contracts,” Espinosa said. “They may award fewer contracts, or [think it’s] easier to hire temporary consultants than to lay off an entire department, or decide they need help streamlining and bring in even more consultants. A lot is still unknown.” An annual survey of 366 government consulting firms recently released by Deltek Inc., an information-solutions firm based in Herndon, Virginia, shows that the No. 1 financial challenge these firms expect going forward is the “Decreasing and/or Unpredictable Federal Spending Environment.” The industry’s complete reversal in self-outlook reflects this worry. While most respondents of the 2011 survey on average predicted a staggering 20 percent growth rate from 2011 to 2012—nearly three times the actual rate of 7 percent—expectations for 2012–2013 are a much more subdued 0-9 percent growth. “The industry is definitely changing in light of [government] cost cutting,” said Deogracias. “It’s possible we’ve seen some decline [in growth], but it’s still a steady industry.” Steady, and increasing in profit. Firms of all sizes reported an increase in profit margins from 2011 to 2012. Of the largest firms that completed the survey—those that did more than $100 million of business in 2012—13 percent reported an increase in profit of more than 15 percent. But whether those numbers will continue to rise is anyone’s guess.

Moving Forward As bright as the industry has become, its future is nearly as uncertain. As sequestration continues— mandated by the Budget Control Act of 2011, which calls for federal budget cuts of $917 billion by 2021—many government departments and agencies will have to do the same work with less money. Whether or not this will have a negative effect on the federal consulting industry is up for debate. “It’s hard to guess how [government agencies] are going to let the sequester impact their consulting

Mark Clark, Associate professor

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Where the Work Is There’s no denying DC is a town of consultants, particularly federal. Of the top 200 federal contractors by dollars awarded in 2012, nearly 20 percent have company headquarters in the area. According to a report by Bloomberg Government, 32 companies in the greater Washington area won more than $104 billion, or 20 percent, of all contract dollars just last year. A high concentration of big firms acts as a magnet for those interested in getting into federal consulting. “We are right in the middle of the strongest market for federal consultants,” said Professor J. Alberto Espinosa, who has seen many of his students enter the IT consulting field after graduation. “This is a big reason why our students come here.” According to Arlene Hill, director of the Kogod Center for Career Development, since 2009 at least 15 percent of MBA students employed after graduation have entered the federal consulting field. In 2010, all graduates who went into consulting were on the federal side.

“As more and more firms and agencies realize it’s a better use of their resources...we’re going to see an even bigger need.”

kogod Tax Center

Exorcising the Tax Code Small businesses spend more than $16 billion each year hiring tax professionals to provide advice and to handle the messy job of preparing and filing their federal tax returns. Is this out of laziness, or greed?

Article By David J. Kautter AND Jackie Zajac

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More likely than not, it’s because understanding and complying with the tax law isn’t nearly as simple as it should be. Taxes are an issue every small business has to deal with. Ideally, they’re a minor inconvenience compared to trying to grow a business and create jobs. There is a system in the tax law that is supposed to be simple for small businesses, but Congress and the IRS have managed to make it way more complicated than is necessary. It is not news that the Internal Revenue Code is too complex for the average citizen. We have all heard the statistics about the code’s length (more than 4 million words) and all-too-frequent edits (over 4,000 since 2001). “If tax compliance were an industry, it would be one of the largest in the United States,” according to Nina E. Olson, the IRS National Taxpayer Advocate. As a tax accountant, allow me to express my professional gratitude to the US government. However, many of our country’s small businesses are not at all enthusiastic about the system we have, and it’s easy to understand why. As the president of the American Apparel and Footwear Association recently put it to the US House of Representatives: A successfully reformed code would be transparent, include clear requirements, and be geared towards allowing businesses to easily pay their fair share without being unnecessarily burdened by determining exactly what that share consists of. Further, “small business” is something of a misnomer; small businesses account for more than half of the jobs in the United States. Depending on how you calculate and cut off the designation, they could represent as much as 98 percent of

all US employers. More than that, they are generally acknowledged to be the greatest source of job creation in the country. In the aggregate, there is nothing “small” about small business. Anything-but-Standard Practice The business owner’s task with taxes is twofold. First, income needs to be determined accurately; second, qualifying expenses need to be computed properly. There are two methods available to so-called “mom-and-pop” shops to determine their taxable income: the accrual method, which is vastly more complicated, and the cash method, widely viewed as the lesser of two evils. Under the accrual method, a transaction is usually considered income when something is sold or a service delivered, regardless of when money comes in the door. This can leave business owners high and dry with taxable income, even though they are dealing with bounced checks and cashflow issues if customers are behind on payment. When it comes to expenses, the rules are even more complex. However, qualification to use the simpler cash method is limited. For example, any business that buys or sells merchandise is required to use the accrual method of accounting. A little more than a decade ago, the IRS allowed businesses with less than $1 million in gross receipts to use the cash method; it then extended that to $10 million, unless a business was precluded specifically by the tax law from using the cash method. Once a business qualifies to use the cash method, the owner must clear the next, bigger hurdle: actually computing the taxes.

Beyond Income And Expenses

85% Small businesses that use a tax practitioner or accountant

Expenses Believe it or not, computing deductions under the cash method is far more difficult than determining income. In general, under the cash method a deduction is permitted when payment is made. There are, however, four complicated exceptions to this seemingly straightforward rule:

2.5 Billions of hours spent complying with tax filing requirements, which equates to 1.25 million fulltime jobs

1 in 3 Small business owners who spend more than three weeks filing federal taxes

1. Prepayments, which are not deductible if the good or service is provided more than one year after payment is made.

Of small businesses spend 40+ hours preparing taxes (up from 57%)

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Determining Income Despite its innocuous name, the “cash method” of accounting is far from simple. When it comes to income, this is largely due to three judicial doctrines—constructive receipt, economic benefit, and cash equivalent—that require taxpayers to recognize income (and pay taxes on it) even though they may not have received cash in the literal sense. For example, income must be recognized if the cash is made available to the taxpayer, regardless of whether the cash itself is in the taxpayer’s physical possession—such as when a customer offers to pay but the taxpayer does not stop by to pick up the cash or check. These judicial theories can result in taxes being owed even though the taxpayer does not have any cash in hand; consequently, they can impose a severe cash flow problem on small businesses that are facing immediate and intractable expenses, such as rent, salaries, and equipment. The three theories are designed to prevent deferral of income recognition, but small businesses usually do not have the resources to engage in sophisticated tax manipulation strategies. They have expenses they have to pay with cash. Moreover, the benefit to the federal government of applying these intricate tax theories to small businesses is likely minimal, since small businesses would regardless receive the cash at some point in the not-too-distant future.

kogod Tax Center

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Type of Expenses

Current Simplified Cash Method Cash Method

Prepayment of expense

Deductible when paid if prepayment does not exceed one year

Deductible when payment is made

Inventory

Deductible when sold

Deductible when purchased

Start-up expense

Deductible up to $5,000

Deductible when payment is made

Depreciable property

Deductible over a 3 to 39 year period

Materials, supplies, and improvements

Capitalized or deducted

Deductible when purchased

unless either: (1) aggregate cost of depreciable assets exceeds certain dollar threshold or (2) asset is a â&#x20AC;&#x153;long-lived assetâ&#x20AC;?

Deductible when purchased

2. Depreciation, in which deductions must be spread over recovery periods of three to 39 years.

The Kogod Tax Center proposes that taxable income be computed as follows:

3. Inventory, the cost of which is deducted only when the inventory is sold.

Cash receipts minus expenses, including: 1. Inventory

4. Capitalization, meaning that certain expenses must be capitalized and deducted in the future. The bottom line is that the current cash method is based on convoluted tax principles rather than on simplicity. A truer measure of taxation for small business would be focused on actual cash flow.

2. Prepayments 3. Materials and supplies 4. Depreciable property = Taxable income. This means the end result would be based only on amounts actually received or paid during the tax year. It’s a more fundamental, back-to-basics approach—a “checkbook” approach to examining checks cut and deposits made. “Income” would mean only cash, property, or services received, without regard to the judicial doctrines that determine imputed income. “Expenses” would mean amounts paid to run the business, including inventory, which would be deducted in full when paid for—not when sold. A threshold of $10 million in gross receipts for a business to be eligible for this method would mean that more than 99 percent of all small businesses would qualify. Aside from the benefits to the small businesses themselves, we believe this approach would result in a more focused, efficient overall tax system, with little or no loss of tax revenue.

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Our Method In 2007, after encouragement from the George W. Bush administration, the Treasury put forth a simplified reporting method for small businesses. The President’s Economic Recovery Advisory Board supported it. Unsurprisingly, these political and economic minds concluded that the taxpayers’ time would be better spent on more productive endeavors, such as actually running a business. Nothing came of it; no legislation was ever introduced, and it was not put forward formally by any administration. It just languished in time and space. We respectfully submit a proposal for a simplified cash method of accounting for small businesses. This proposal has been put forward to the House Committee on Ways and Means’ Tax Reform Working Group on Small Business and Pass-Through Entities and others engaged in the tax-legislation process.

Kogod Standout

Finding Opportunity Underwater

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The view from Tim Richards’s seat is a colorful one, teeming with tropical fish, coral, and sea creatures. And that’s the idea. Richards, MBA ’13, founded ReefCam in 2012 with four classmates. Their mission: to place high-definition video cameras next to coral reefs and provide streaming footage of the underwater world. ReefCam will sell access to the video streams to universities, research organizations, and resorts and businesses. The start-up represents a new wave of business, committing to donate 25 percent of its profits to conservation, education, and research. Richards, who has a background in environmental science, saw ReefCam as a perfect opportunity for “people to see how awesome the natural environment is, why it’s worth enjoying and conserving.” He and his team are currently negotiating with potential partners and developing a mobile app to make the video content more accessible. The company’s endgame? “To prove that this is a useful and long-lived way to show real, epic scenery to as many people as possible,” Richards said. “Then I would call ReefCam a success.” Photographer: Vincent Ricardel

John Monterubio, JD/MBA ’13, Tim Richards, MBA ’13, Alex Zajac, MBA ’13, and David Bidwell, MBA ’13, photographed at the Key Bridge Boathouse in Washington, DC. Not pictured: Noah Gray, BA '14

KOGOD NOW FALL 2013 | kogodnow.com

What Hospitals Can Learn From Hotels Twenty percent off a midweek reservation. Stay a second night free. Sounds like a good deal, no? What about one-third off a knee replacement? Somehow, that’s less appealing. When business hotels struggle to stay at capacity during off-peak times, online travel agencies such as Expedia and Kayak can step in with lower rates to fill the rooms.

Article By Danielle Marks

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Many hospitals suffer with similar occupancy issues. Outside of peak hours and during summer months, the vacancy rate can exceed 50 percent. But hospitals haven’t been able to seize the opportunity to offer price cuts on rooms or elective procedures during non-peak periods in the same way that hotels do. Similarly, providers of tests such as magnetic resonance imaging do not offer peak and off-peak pricing. Professor Peter Chinloy, a real estate finance expert, noticed the similarities between the two industries when he started studying data on hospital occupancy. Health-care officials have also looked at the hotel industry’s off-peak pricing as ripe for reproduction. In his research on hospital occupancy, Chinloy came across a comment from Michael Leavitt, former US Secretary of Health and Human Services, which echoed his thoughts on the parallels between hotels and hospitals. “Medical care should be no different than hotels. On the back of my hotel room door in San Francisco was a sign that said the price of the room was $449. My actual bill was $130 instead of $449 because the government had negotiated special prices,” Leavitt said. “With hotels I have the ability to ask what the rate is or go online, and they will actually search and tell me what various hotels are charging. None of that is available in health care.” With Isaac Megbolugbe, associate professor at Johns Hopkins University’s Carey School of Business, and retired Kogod instructor John D. Benjamin, Chinloy developed a model of health-

care facilities and found that although hospital bed counts have fallen in the United States, vacancy rates have risen. Since 1980, the hospital bed vacancy rate has exceeded 30 percent, even as capacity has been reduced, according to Chinloy’s research. The average yearly cost of an empty bed at a hospital was estimated between $53,000 and $114,000 in 1995 dollars—a wide range, to be sure. Some of that excess capacity is rightly available for “surge” situations, like the recent bombing at the Boston Marathon. The latest research from the Centers for Disease Control and Prevention indicates that in the United States, the average hospital occupancy rate in 2010 was 65 percent. Places like Washington, DC, have stronger occupancy rates, Chinloy said, because of relatively stable yearround employment rates. But states such as Florida have high seasonal vacancy rates. Pay for Play In single-payer markets such as Canada and Europe, vacancy rates are not an issue. Patients wait longer for non-emergency care, such as hip or knee replacements, but they also do not have the option of choosing their medical-care provider. Summer and weekend elective surgeries happen less often in the US because those times are not as convenient for Americans. But if hospitals adopted a similar model to hotels and posted their prices for non-emergency procedures (with lower costs for

PETER CHINLOY, PROFESSOR

Medicare regulates costs for people over the age of 65, and hospitals negotiate reimbursement through insurance carriers for most of the rest of the population. Aside from what Sloan calls “charity cases,” a small percentage would pay the rates out of pocket and receive the off-peak discount. In Washington, DC’s Northwest quadrant, for instance, Sloan noted that 95 percent of patients are covered by insurance. He said hospital patients are less sensitive to cost than hotel guests, since they don’t typically pay out of pocket. For patients paying with insurance, the theoretical discount would be passed on to the insurer. “The research is interesting and we need more ideas and research on improving efficiency,” Sloan said, “but any suggestion has countervailing theories because of the complexity of the healthcare system.” "Hospitals: The Market for Health Care Facilities," Peter Chinloy, John D. Benjamin, and Isaac F. Megbolugbe, was published in Real Estate Economics in 2007.

A Dose of Reality Bob Sloan, Executive-in-Residence and former president and CEO of Sibley Hospital, said that while Chinloy’s research is innovative, putting the idea into practice would be a considerable challenge.

“When [doctors] start practicing, they work 9 to 5, Monday to Friday. The system is built around a schedule that’s not using the space effectively.”

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services at, say, 2:00 a.m. or on a Sunday evening), Chinloy said, vacancies might fall. “When young doctors are residents, they work in the hospital for 80 hours a week, such as in [the TV show] Grey’s Anatomy,” Chinloy said. “Yet when they start practicing, they work 9 to 5, Monday to Friday. The system is built around a schedule that’s not using the space effectively.” Chinloy suggests that the doctors and specialists could be better compensated for working during off-hours. Since medical reimbursement frequently involves separate facility and doctor fees, there would be tradeoffs between the two. Reduced off-peak facility fees compensate doctors and providers. This method could also address increased compensation for younger doctors with high student loan debt. He also could see the hotel pricing model working well for the costly machines that doctors use to perform MRIs and CT scans. Those machines are often bottlenecked because there are so many patients who need to use them, but they are only operated during certain hours. It’s possible, Chinloy said, that the machines could be used more effectively if they were operated during off hours at a lower cost to patients.

PRACTITIONER PERSPECTIVE

An Inside View of Dodd-Frank In recent memory, two major cataclysms have rocked our markets: the accounting scandal of 2002 and the financial-market panic of 2008. Both had significant impacts on the stock market, with equities tracked on the Dow Jones Industrial Average falling by more than 30 percent—reaching a low of 7,286 points on October 4, 2002, and hitting an even greater low of 6,547 on March 9, 2009.

Aaron Klein is director of the Financial Regulatory Reform Initiative at the Bipartisan Policy Center. While at the Treasury, he helped craft the Dodd-Frank Act. He has also served on the Senate Banking, Housing and Urban Affairs Committee.

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The federal government responded to each with sweeping overhauls of the policies regulating the affected sectors. The first resulted in the SarbanesOxley Act of 2002, while the second led to the Wall Street Reform and Consumer Protection Act of 2010, better known as the Dodd-Frank Act. I watched and reacted to both of these storms up close, first as an economist for Senator Paul Sarbanes (D-MD), and then as Senate Banking Committee Chair Christopher Dodd’s (D-CT) chief economist and as Deputy Assistant Secretary of the Treasury under Secretary Timothy Geithner. In both instances, the sense of crisis was palpable. In 2002, it seemed as though every week a company with a household name collapsed. The week that the Sarbanes-Oxley Act (in an early form) was first approved by the Senate Banking Committee—the first step in the traditional legislative process—the accounting debacle took down WorldCom. While the problems at Enron may have grabbed more of the headlines, WorldCom was actually a much larger bankruptcy. Certainly, the failures of the financial crisis— Bear Stearns, Lehman, AIG, Wachovia, Fannie, Freddie, General Motors, and Chrysler—are fresher in our minds. Most were handled at some point by the government through special legislation, including the Emergency Economic Stabilization Act of 2008, which established the Troubled Asset Relief Program (TARP). Despite their similarities, these two upheavals affected the overall economy very differently. One led to the greatest recession since the Great Depression, while the other was halted in its tracks. The economy continued to grow and, although many individuals and communities felt significant effects, the accounting crisis did not lead to a recession, let alone a global financial meltdown. One of the main reasons for the difference is the unique role that our financial services sector plays in our economy. The financial services sector serves as an intermediary, connecting individuals and businesses who wish to invest (savers) with those who have productive uses for those funds (borrowers). Banks obtain money from a broad range of savers, and

then make loans to potential borrowers on terms that compensate the bank for the risk they assume, plus a profit. In the absence of banks and other financial services companies, individual savers and borrowers would have to find ways to connect with each other, learn to trust one another, and arrive at mutually agreeable terms for borrowing—a very expensive, inefficient, and risky process. The role that banks and other companies fill as financial intermediaries is tremendously beneficial to any economy. Much like oil in a car, financial intermediation lubricates our economy by ensuring that money is properly circulated throughout our economic engine. Unfortunately, this means that financial crises have the potential to cause greater damage than other types of crises. If another sector in the American economy fell into distress, the harm to our economy would be real, but likely limited to that sector. With a sufficiently diverse economy, such a crisis would not be likely to spill over into every other sector. However, because the financial system serves as a lubricant to all sectors of the economy, a catastrophe in that sector affects almost everyone. When the financial sector enters a crisis, the typical first reaction of financial companies is to stop lending and hoard cash so that they can survive in a more uncertain environment. However, as we learned too well after 2008, when financial companies stop lending, the effects are felt on Main Street. When banks don’t lend, businesses and consumers suffer. Worse yet, suffering businesses reduce hiring and often resort to layoffs, leading to higher unemployment and a decline in consumer spending. This can become a vicious cycle. No wonder there was bipartisan action by Congress in the Bush and Obama administrations to prevent the collapse of the financial system. Understandably, these responses have led to public backlash, which has reasonably focused on the idea that some financial companies are “too big to fail.” One of the central goals of Dodd-Frank was to tackle this problem. The legislation’s very first sentence is, “An Act to promote the financial stability of the United States by improving account-

erly implemented—the debt would form the basis for equity in a new, hopefully failure-free, company. BPC recommends several important modifications to the bankruptcy code that could allow it to function in a similar manner, with or without the FDIC’s involvement. We believe a workable, reformed bankruptcy system is preferable to an FDIC-led resolution. Our research indicated that this approach could be considered a breakthrough, allowing any systemically important financial companies to be properly resolved without requiring a taxpayerfinanced bailout or triggering a destructive financial meltdown. BPC’s full report, “Too Big to Fail: The Path to a Solution,” goes into greater detail about how this could work and makes more than 40 specific recommendations to financial regulators and Congress on how to improve the system. These include requiring that the holding company’s long-term debt be at least one year in duration; that the FDIC should confirm it will not use its general discretion to discriminate among similarly situated creditors; and that the FDIC and the Federal Reserve should better align the “living will” resolution planning process (required under Dodd-Frank) to the potential use of the single point of entry regime. History is quite clear: eventually, there will be another financial crisis. There will also be another accounting crisis. The measure of the policies enacted is not whether they prevent any future calamity from occurring; that is impossible. The real test will come when the next crisis materializes, and we all discover how vigorous these policies are in mitigating the potentially disastrous effects. After the Great Depression, we created deposit insurance. It didn’t stop bank failures; witness the savings and loan fiasco of the 1980s or the recent financial panic. It did, however, create a framework that protected millions of American families and businesses, and made those crises far less damaging than they otherwise would have been. With any luck, we will be able to say the same thing about the “too big to fail” provision in Dodd-Frank.

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ability and transparency in the financial system, to end 'too big to fail,' to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practice, and for other purposes.” However, the question of “too big to fail” contains two separate issues. The first is whether financial companies of a certain size are undesirable merely because of their size—whether they are simply “too big.” The second question is whether the failure of a specific firm would result in a broad financial crisis; in other words, whether we have a system where every financial company, regardless of size, can be allowed “to fail” without causing serious damage to the entire financial system. In examining the efficacy of Dodd-Frank at the Bipartisan Policy Center (BPC), we considered whether implementing legislation has put us on a path to solve the “to fail” problem. The law’s main tool to accomplish this was the expansion of powers to the Federal Deposit Insurance Corporation (FDIC), authorizing it to develop a new failure resolution regime capable of handling the failure of any systemically important financial institution (SIFI). The FDIC’s failure resolution authority before Dodd-Frank was limited. Before the crisis, the FDIC could only resolve commercial banks; the agency lacked authority over Bear Stearns, Lehman Brothers, and AIG. Dodd-Frank transformed this, giving the FDIC broad new powers to develop a new system for these non-bank SIFIs. Yet Dodd-Frank did not prescribe exactly what regime the FDIC should implement. Thus, even after the act’s passage, doubts remained about whether the FDIC would be able to develop and implement a system that could reasonably allow any SIFI to fail without requiring a bailout or causing a financial panic. The FDIC responded by proposing a new system known as “single point of entry.” Under this system, the top level of the failed company (the holding company) would be put into receivership, while its operating subsidiary companies would continue to operate. As long as the holding company had enough long-term debt that it could not flee in a crisis—a critical requirement which must be prop-

Guilt by Association For almost three years, the United States’ Commodity Futures Trading Commission (CFTC) has been working to draft and implement new regulations for the $633 trillion global swaps market. Article By Ben Mook

From their inception, swaps—derivatives where two parties exchange financial instruments such as interest rates, cash flows, or credit defaults— had been treated as contracts between individuals. This allowed them to be traded over the counter (OTC), with no required reporting of transactions to a government agency. In the wake of the US financial crisis, however, there was a new legislative focus placed on the regulation of these derivatives. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 called for swaps to be traded on open exchanges or other platforms, the same as stocks and futures— and with similar reporting requirements. Dodd-Frank ceded oversight of derivatives to the CFTC, leaving it to the agency to determine how to implement the new rules. James Moser was party to the wrangling over efforts to regulate derivative trading. He came to Kogod in 2012 after nearly six years as deputy chief economist with the CFTC. Looking back, Moser said lawmakers cast a wide net on all OTC derivatives, when putting a narrow focus on the biggest problem—credit default swaps—would have tightened up the process significantly and made the biggest impact. “In my view, we went after the entire enchilada—all derivatives—when we should have been focusing on credit default swaps,” Moser said. “Credit default swaps were the main source of the problem.”

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Risky Business Although credit default swaps—undisputed villains of the financial crisis—account for only about 5 percent of the swap positions, they have had a much larger impact on the economy than that figure might suggest. In credit default swaps, the lender attempts to hedge against default by paying a third party for protection—insurance in case the debtor, or debtors, defaults. The problems started when the parties selling the “insurance,” such as American International Group (AIG), were unable to keep up with mounting defaults. AIG had to be bailed out at a taxpayer cost of $180 billion.

According to the Bank for International Settlements, the notional value of credit default swaps at the end of 2012 was $25.1 trillion; OTC derivatives as a whole had a notional value of $633 trillion at the end of the year. Moser said credit default swaps were initially seen as a way to protect against possible defaults. But, he said, no one took a big-picture view of what would happen if the whole system collapsed, as it did when the real estate bubble burst. “People thought with credit default swaps, ‘Hey, this is the solution,’” Moser said. “And it turned out to actually be the problem.” Misguided Approach? In May, despite opposition from the industry and budget constraints stemming from GOP opposition to the regulation, CFTC commissioners approved the first substantive changes to OTC derivative trading. All derivatives were targeted, not just credit default swaps—an approach that Moser believes was too broad. “Save for [credit default swap] contracts, which constitute a small portion of the derivatives markets, there were very few problems with derivatives during the financial crisis,” he said. “Were Dodd-Frank focused on the source of the 2008 problems, financial regulators would be working almost entirely on appropriate regulation of CDS contracts. Instead, most of their effort has been focused elsewhere.” While the May orders took a major step forward in pushing derivative trading into the open, some unaddressed areas could still have a major impact. One contentious issue deals with how regulations should be applied to international institutions (or the foreign affiliates of domestic ones). Moser said he anticipates a lot more battling over how to implement Dodd-Frank before the war is over. “The rules are still being written and there is still quite a bit of pushback,” he noted. “But the pendulum is swinging in the direction of the regulators, and I think the CFTC is going to push very hard to get what they want while it is like that.”

KOGOD NOW Editor

Jackie Zajac Publisher

Lara Kline Contributors

Amy Burroughs Max Chilkov Laura Herring David J. Kautter Andrea Orr Danielle Marks David Todd Marketing

Max Chilkov Laurie Enceneat Digital Support

Laura Caruso Design and illustration

Design Army Copy Editor

Carmel Ferrer

Kogod Now, published twice annually, is the official magazine of the Kogod School of Business

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