This week the administration begins a serious behind-the-scenes charm offensive on its regulatory reform plans. The argument seems to be: we are where we are on banks’ solvency/recapitalization, so let’s not argue about that; it’s time to strengthen financial regulation in line with our G20 commitments.
But there is a serious dilemma lurking behind the foreshadowing, the rhetoric, and the talking points. (Aside to Treasury: please find somone other than big financial players to endorse your next 100 days report; many taxpayers will find p.5 of your first report particularly annoying – if you don’t understand this point, you are too close to the big banks.)
Here’s the problem.
At this point in most financial crises, you would have a big recapitalization program underway – with or without the trappings of a formal insolvency process. Bank executives would be out, and new teams would be well on their way to figuring out how risk control systems broke down so completely and deciding how much of the business can be sold off vs. restructured vs. closed. Obviously, we are somewhere quite different – in our brave new post-stress test world, the insiders who run these banks feel like they just won the lottery (or perhaps that’s the right to run all future lotteries, with most of the winning tickets reserved for themselves and with the government footing the bill for any potential losses?)
The political pressure to regulate tightly in this environment is obvious and, with every further public relations gaffe by the industry and inspector general investigation into its friends, the legislative agenda will get tougher on banks.
There is an obvious economic case for tightening regulation – after all, even the people who ran the Great Deregulation from Treasury during the 1990s now say, “when the facts change, we change our minds”. But the lack of sensible upfront recapitalization for the banks means that they will be tempted to go even further in terms of regulatory tightening. After all, the incentives for executives running banks are now all messed up – irrespective of whether they were really Too Big To Fail in the past, they’re all convinced they are Way Too Important To Fail today.
If your bank fails at the same time as all other banks fail or hit serious trouble, there will be a bailout. The implication is that bank executives should copy the behavior of others, as much as possible; above all else, don’t do anything different – idiosyncratic risk is the real danger. Chuck Prince (former head of Citi) nailed this, as well as a good portion of your retirement savings:
When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing. (July 2007)
The dilemma, of course, is that you don’t really want to overtighten regulations on banks during a recession – this will further discourage lending. This was an important rationale for doing an upfront recapitalization and forcing a change of control in big banks. When we missed that opportunity, we essentially set ourselves up for “procyclical regulation”.
And if you think we can punt on regulation and come back to the issue when the economy looks stronger, you need to spend more time on Capitol Hill. The banks are already bouncing back in terms of political clout, and they have a simple regulatory answer: nothing meaningful. So if you support the end of deregulation, you need to push for it now.
By the way, is Chuck Prince still rich?
By Simon Johnson
The Baseline Scenario 
Why didn’t/doesn’t the government just direct more $ to the Credit Unions and Community Banks who had/have, generally speaking, never got involved in CDS’s etc., done their lending responsibly and continue to remain solvent. Has anyone written a scenario of what the world would look like if we did let these criminals-you are far too charitable to describe them as lottery winners-fail?
In a better world, it would be great for an unbiased panel of
financial experts to do an open investigation of what went wrong first. Regulations should then flow from the analysis of what went wrong.
That being said, an unbiased study will never happen. The big boys and girls in politics and the banks can not afford for the public to know why the collapse happened, because those very same people will be implicated.
Also in a better world, if fraud occurred and that fraud led to the collapse, those guilty should be tried and if convicted, severely punished. New regulations or not, enforcing existing laws should happen irregardless.
Of course, banking fraud investigations will never happen either. Because we are well along into being a crony capitalist, or perhaps a crony socialist State. Such fraud investigations would upset the extremely lucrative pay to play schemes now benefiting our political class and we just can’t have that can we?
Well, the article sounds realistically pessimistic as to the prospect for future significant change in banking regulations. Nothing can be done in the short term because we’re still in a fragile state. Nothing can be done in the medium term because when things pick up the charge of “you’ll ruin this recovery” is likely to be persuasive. And it’s possible that nothing will be done in the long term because the pressure will be off (and motivation lacking) to take on the newly refreshed clout of the financial institutions.
So, it seems reasonable for those that want to see such change to develop a kind of political contingency plan for the possibility that the temptation to do “nothing meaningful” will be otherwise irresistible when the Congress finally gets around to considering these new regulations.
I propose keeping a good website publicly accounting for exactly how much money taxpayers have lost at each institution. When I tell people about Chrysler – a drop in the bucket compared to other public outlays – their veins pop out of their foreheads, and these are people who are largely sympathetic to the plight of American manufacturing. A few years from now those huge losses will still retain their infuriating character, and the desire for reform to prevent a recurrence of the present situation could be maintained.
No one likes the idea of paying high taxes to offset these loses – knowing that bankers are still making fortunes in profitable institutions whose survival was guaranteed by the public, but that won’t be required to pay it back, in full, with interest – just like the bank would demand its customers to do.
Searching Lexus-Nexus, Google and other engines, I couldn’t come up with ONE instance where either a journalist (a rare specimen today, among all the ditto-heads) a regulator or a Congressperson has publicly ask Treasury or the Fed, WHY current management of the big banks are still sitting in their corner office.
The government does not suffer from regulatory capture; it’s more like mind control by the financial industry.
yes, it’s a dilemma, that’s why we must think carefully about it.
The bankers and board members at the helm leading into this banking crisis should — not be allowed — to keep their jobs. If they are not fired they should do the right thing and retire.
The financial oligarchy runs this country. One of their own is running Treasury and as Dick Durban recently said, they own congress. Under these circumstances re-regulation is a pipe dream. Why keep harping on it. It’s not going to happen. Pundits should spend their time discussing ways to defeat the oligarchy. This is a political problem at the grass roots level. At this point nothing short of a full on depression that punishes every voter will result in any change in the status quo. This time the populists are right. It’s time to bring out the pitchforks.
There cannot be any meaningful regulatory reform without a thorough analysis of what went wrong in the past 10-15 years and what were the main causes of the current crisis. There are many explanations today: too many regulators, lack of will to apply existing regulation, lack of true independence by the regulators, cross-broder regulatory and tax arbitrage, lack of systemic risk regulation, unchecked securitization, unchecked rating agencies, bank compensation structure, over-reliance on mathematical models, excessive liquidity injections by the Fed, etc.
Doesn’t one need to understand what to reform before launching the reform?
Isn’t this a new kind of Hooverism? Or maybe just Hooverism, all over again–I’m not sure of the history. Fund the banks, then discourage them from lending the money out where it would be most useful?
Thanks for an excellent post, Mr. Simon.
I read “page 5” and am absolutely delighted that Bill Gross of Pimco is excited about the “potential for double digit returns” for his firm.
And I’m simply ecstatic that BlackRock is “exploring” the creation of mutual funds that (after nominal management fees and expenses) will allow individual investors like me to share in this “win-win-win policy”.
WOO HOO!
Please excuse my error. I mean to type “Thanks for an excellent post, Mr. Johnson”
The correct name of this policy should be “win-win-wink”
Prof. Johnson,
Are you sure there is risk of regulatory over-tightening? I think not.
Friedmenites like Summers are neo-Friedmenites, that is all. Greed is still king, and business schools will take their time to look and teach “beyond greed.” (Some) Congressmen hit their heads on the walls that Dr. Summers hates construction or that Dr. Summers hates manufacturing — and we see the results, Chrysler is allowed to go bankrupt and take down 789 dealerships, GM on its way to bankruptcy is taking down 1100 dealerships, yet creme-de-la-creme banks like Goldman which would have gone bankrupt sans the 10 billion dollar TARP plus the $12.8 billion dollar TARP derived AIG handout, paid nice bonus to execs in 2008 and boldly proclaimed recently that the 2009 bonus will match the 2008. Car salesmen will lose their jobs, but Dr. Summers will try to save as many bank jobs as he can. The average American thinks that the car salesman is a conman. But these sales folks are really gullible people compared to the sophisticated bankers and their planted reps at all levels of the administration…
Now, I read some financial engineering in MIT Sloan while pursuing my MBA there 9 years ago, and you can listen to my views in my last weekly which aired less than 12 hours ago at — http://tinyurl.com/q2gt2t — in this weekly podcast, I have suggested to the Administration that reform should be both a bottom up and a top down approach — pull back the Goldman bonus for 2008 by taxing it at 100% and return the money to the taxpayers.
You can also read my article where I have shown that the actual bailout ($8.7 trillion) + stock-market handout ($5 trillion) is equivalent to the American economy / GDP of $14 trillion dollars. I call it the 14 trillion dollar value drain (similar to value chain analysis of Porter, except that instead of creating value, the banker parasites drained value), and the article is located at http://www.franconomics.com/fourteen-trillion-dollar-value-drain-II.html
I found that you are now an economic advisor to Congress. Keep pushing the agenda that radical reform demands that bank executives get NO BONUS, and that includes top (Goldman) to bottom (Citi)…
Best regards,
Sam, MBA (MIT Sloan)
On what planet is the Capital Assistance Program NOT a “big recapitalization program”? It’s one thing to disagree with the administration’s approach to the banks, but it’s quite another to simply ignore the administration’s existing programs.
And has Simon Johnson ever cited a specific financial regulation that he supports, and which is in danger of not being implemented? I guess vague platitudes about the need for “more regulations” and some mysterious and undefined “financial oligarchy” is just Johnson’s shtick. It’s kind of sad that people still consider this guy an expert.
The strategy is very obvious… If you change the management of the Banks the new ones will expose how much trouble they are in.. So the management remains the same to shield the facts… The Government funds the liquidity crisis.. (Meaning bail out the share holders).. And the economy recovers… Everybody goes home and is a winner except the Tax Payers… Who cares for them…