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The Wall Street Leviathan

The Dodd-Frank Act would now place all financial firms, not just commercial banks that take deposits, under firmer capital restrictions. It calls for useful changes in credit ratings agencies, which had profound conflicts of interest because they supplied ratings to the issuers that paid them. The FCIC report clearly describes the battle for market share by Moody’s, one of the largest of them, and its willingness to provide artificially high ratings. But the new proposals still await implementation. Dodd-Frank would also require what has been the secret unregulated trading of derivatives—a source of so much risk-taking—to be done openly by clearinghouses that can also set capital requirements for any trades—that is, margin requirements. But this, too, is a long way from being implemented.

In fairness, some of the regulatory agencies have been undertaking firmer regulation. The SEC is making a broad investigation of insider trading by hedge funds, and the Justice Department is prosecuting several flagrant cases. The FDIC is targeting bank executives for possibly fraudulent behavior in several hundred institutions that have failed. The Dodd-Frank legislation requires that executive compensation, including bonuses, be more openly revealed and shareholders be given a voice in how much executives of financial firms earn. Other agencies are also setting rules to limit compensation. The Obama administration may try to impose fines on particularly irresponsible mortgage servicers like Wells Fargo and Bank of America in order to finance reductions in the principal many homeowners now owe on their mortgages.

But all these reforms may be undermined by pressures from Wall Street and the belligerent Republican majority in the House. The SEC recently proposed banning some bonuses paid by financial firms if they encourage inappropriate risk-taking. The measure was passed only by a three-to-two vote with the three Democratic appointees to the SEC for it and the two Republican appointees against. A new president could easily shift the balance. Republican lawmakers are trying hard to cut back the budgets of the SEC and the Commodity Futures Trading Commission.

One refreshing sign of hope for constructive change is that economists, some of whose theories had much to do with a light regulatory approach toward derivatives and the housing bubble, are increasingly producing research calling for stricter guidelines than Dodd-Frank or the Obama administration. Regulating Wall Street presents a wide range of new research supporting stronger regulations than Dodd-Frank recommends, such as the tax proposals I mentioned earlier. In Reforming US Financial Markets, Robert Shiller also describes new economic theories that take into account more realistic appraisals of how Wall Street works and demonstrates why more effective regulation is necessary. The old theory of rational markets, which laid the groundwork for light regulation, “is one of the most remarkable errors in the history of thought,” Shiller writes. He believes that regulators can and should decide to raise capital requirements during periods of excessive speculation.

In the prologue of Regulating Wall Street, the editors, hardly known as progressives, remind financiers how useful strong regulations were in the past:

Many players on Wall Street and in corporate America in the 1930s hated the new regulatory regime imposed on them…. But in the long run…the new regulatory regime was one of the best things that ever happened for Wall Street and corporate America. Why? Because it created confidence among investors—then and in the decades to follow—that Wall Street finally had become a level playing field.

We would be far better off if the powers on Wall Street would remember this lesson.

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