The financial reregulation package just passed by Congress is far from a comprehensive reform of American finance. Despite the enormous threat to the world’s financial markets created by the failure of Lehman Brothers and the stunning excesses of insurance giant AIG and banking conglomerate Citigroup, the reforms are in truth modest. Neither the Obama administration nor Congress opted to cut banks down to size, and the bill is only placing mild limits on risky banking activities. The giant financial institutions, meanwhile, are as big—even bigger—than ever and bankers’ compensation is once again at stunning levels.
But the problem with the legislation is not merely its small scale. It is the way it is supposed to be implemented: to avoid controversy and get the bill passed, congressional reformers foisted the responsibility for setting most of the specific, sticky rules on federal regulators at the Fed, the Securities and Exchange Commission, and elsewhere, who are to make them over the next year or two. These are, for the most part, the same regulators who failed to stop the speculative excesses and ensuing credit crisis of 2008. While they now have a few more tools at their disposal, their already substantial tool box was barely touched in the years leading up to the housing and credit crash and severe recession. Will it be different next time?
To deal with systemic risk, which many believed to be the overriding concern, the bill gives responsibility to a new Financial Stability Oversight Council, comprised of the heads of the SEC, the Federal Deposit Insurance Corporation, and other agencies, and headed by the Treasury Secretary. It will be charged with overseeing the large financial firms whose activities may make them a risk to the entire system. The council will supposedly monitor and expose such firms, require more capital of them, reduce their leverage, and generally make it more expensive for them to borrow.
But there is little to reassure us that regulators will do their job any better than before. Before the recent crisis, the SEC had the power to demand that investment banks take on less leverage; instead, it did the opposite—essentially undoing existing leverage restrictions in 2004. Nor did the Federal Reserve investigate the debt hidden on the books of banks in off-balance sheet vehicles, against which no capital was kept, or even bother to understand the hidden risks of the obscure collateralized debt obligations the banks issued in the hundreds of billions of dollars. Citigroup, for example, lost $48 billion on such CDOs in late 2008. The FDIC could have restrained the banks as well, and did not.
If a firm is truly on the brink of collapse, the new Financial Stability Oversight Council may now decide to put it out of its misery and liquidate it in an orderly fashion. Unlike with TARP—the $700 billion federal bailout for banks administered in the fall of 2008—the government will not bail out shareholders and pay creditors of failing institutions 100 cents on the dollar. Stockholders and creditors will have to pay for the risks they take. This is supposedly a great advance, minimizing so-called moral hazard—the incentive to increase risky behavior that arises when investors know the government will rescue them.
But will the regulators actually make such severe decisions? And if they do, will it be too late? The new oversight council also implicitly promises to throw management out when appropriate. Why this time? Washington was quick to fire the management of General Motors, but bankers, in contrast to auto executives, are perhaps considered a more genteel class—people with whom Washington is cozier and with whom regulators often went to school or from whom they may hope to get a future lucrative job.
The best way to forestall over-speculation and excessive risk-taking by the financial industry as a whole is to impose permanently higher capital requirements and maximum leverage ratios on all major financial institutions—including the entire so-called shadow banking system of major investment banks, hedge funds, and insurance companies. The administration and Congress acknowledge the need for higher standards, but the task of creating them is also being kicked down the road, this time to an international body—perhaps ideally to the Bank for International Settlements in Basel.
Global standards make sense, but recent announcements from the G-20—roughly the twenty most economically powerful nations in the world—suggest the leading economies are already weakening their standards and may not implement new requirements until 2013. Until then, there may be no substantial changes to existing practices.
There are two refreshing reforms in the new bill. The first will force most derivatives out into the open to be traded in clearinghouses or on exchanges. These securities—whose value is based on other securities—have been largely traded in obscurity because federal regulators, including Alan Greenspan and those who reported to the Clinton and Bush administrations, refused to regulate them. The prices on the trillions of dollars worth of credit default swaps, for example, which served as insurance contracts on mortgage securities, will now have to be disclosed rather than, as in the past, set in secret by a relative handful of bankers. The new derivatives rules will also give regulators more control over the credit worthiness of market participants. AIG, for example, sold tens of billions of dollars of insurance with no minimum capital standards—i.e. without sufficient capital on hand to cover anything close to its obligations when the market collapsed. This was a source of major vulnerability in the system.
The second promising reform is the creation of a consumer financial products safety agency, which will oversee consumer loans, including mortgages and credit card loans. Nothing quite symbolizes Washington’s utter irresponsibility as its inattention to warnings from the FBI in 2004 that there was an “epidemic” of fraud in mortgages. Alan Greenspan, among others, chose to look the other way, though the Fed had authority to clamp down on some of the mortgage writing.
But even with these two welcome changes there are disturbing compromises. Some derivatives will be exempted from open trading. In a concession to Wall Street in general, the consumer agency, originally conceived as an independent body, will now be housed in the Fed, long cozy with bankers. Some Senators are already worried about who will run it, lest he or she interfere too much with the lending business. It is also not at all clear how effective efforts to reduce irresponsible ratings set by the ratings agencies will be. The excessive compensation of bankers is barely addressed. The European Union is clamping down much harder.
The unavoidable fact of the matter is that the effectiveness of regulation will depend entirely on how regulators attend to their duties in the future—and how susceptible they may be to the intense lobbying or latest economic ideology to which they will be subjected. Such “regulatory capture” was inadequately discussed in Washington, and the onus will be on Obama, and future presidents, to make sure that key regulatory positions are occupied by dedicated reformers.
The legislation didn’t need to depend so much on the future judgment of regulators. Banks could have been entirely restricted from some kinds of activities, high capital requirements could have been written into law, and the consumer agency could have been made tough and independent of agencies like the Fed whose past record makes them suspect. Finally, the size of banks could have been restricted to a certain percentage of GDP.
There are loud cries that Obama has been anti-business. But one reason the reform package is rather weak is that Obama and his team refused to blame Wall Street bankers—or the irresponsible regulatory record of the Clinton and Bush administrations—for the catastrophe until much later in the process. “Playing nice” seems to be part of Obama’s plan, but it is not working. He did not rally the people to his side to fight the vested interests. In fact, the people rallied him. Only when popular anger towards bankers rose did Obama adopt the “Volcker rule,” for example, which led to the 3 percent limitation on proprietary trading and hedge fund ownership by banks.
What I find most disappointing is that the Obama team did not present its case for regulation based on a diagnosis of what caused the crisis in the first place. His advisers seemed to adopt the widespread notion that everyone had a part in it—a convenient way to blame no one.
One need not make the claim that there is a ready explanation of what happened. But there were clear market failures due to lack of transparent pricing in derivatives, obscure financial instruments like collateralized debt obligations, unambiguous conflicts of interest for credit ratings agencies, and compensation arrangements that stimulated rather than controlled risk-taking by individuals. A set of steps could have been taken to address these specific, generally agreed upon market failures.
There was another kind of market failure, less widely accepted by economists, based on the irrational herd behavior of investors that accounted in part for the enthusiasm for extremely risky and financially dubious mortgage securities. To address such market bubbles requires different kinds of solutions—notably higher capital requirements and maximum leverage restraints. These can be changed with the times, but addressing these issues requires judgment and vigilance.
And there was outright fraud—certainly by writers of subprime mortgages, including not only the infamous Countrywide Financial but also many of the major banks like Citigroup and Bear Stearns. They may have committed fraud in selling the collateralized debt obligations, which were clearly far more risky than they claimed. The corporate fraud laws are not nearly satisfactory. Perhaps the new consumer agency will deal with some of this, perhaps not.
Had the Obama administration categorized the issues more clearly, I believe it would have been able to explain effectively the regulatory package to the public and to Congress, and to provide a stronger shield against the onslaught of financial lobbyists and the misunderstandings of the press, which have served to weaken the reforms during debate in the House and Senate.
What is sad is that many of the future rules and regulations may be set when Obama is no longer president. Notwithstanding the serious weaknesses of the current reforms, for which Obama bears considerable responsibility, it is highly unlikely that anyone who might defeat him in 2012 would set the new rules more wisely and stringently.