Consumer Protection When All Else Fails (Written Testimony)

I took three points away from yesterday’s hearing in the House of Representatives.

  1. We need layers of protection against financial excess.  Think about the financial system as a nuclear power plant, in which you need independent, redundant back-up systems – so if one “super-regulator” fails we don’t incur another 20-40 percentage points in government debt through direct and indirect bailouts.  A consumer financial products protection agency should definitely be part of the package.  Update: The Washington Post reports that such an agency is now in the works; this is a big win for Elizabeth Warren, Brad Miller and others (add appropriate names below).
  2. Congress will work on this.  The intensity of feeling with regard to the need to re-regulate is striking, and there is much that resonates across the political spectrum.
  3. In the end, much of banking is likely to become boring again.  Special interests are convinced that they can fend off the regulatory challenge, but I find this increasingly unlikely.  Enough people have seen through what they did, how they did it, and what they keep on doing.  No doubt the outcomes will be messy and less than optimal, but at this point “less than optimal” is much preferable to “systemic meltdown”.

There is still much to argue about and, no doubt, there will be setbacks.  We’ll get a better or a worse system, depending on how the debate goes.  And if the external scrutiny slips away, so will point #3 above.  But this was still by far the most encouraging hearing I’ve so far attended.

The main points from my written testimony to the subcommittee are below.

1)      The U.S. economic system has evolved relatively efficient ways of handling the insolvency of nonfinancial firms and small or medium-sized financial institutions.  It does not yet have a similarly effective way to deal with the insolvency of large financial institutions.  The dire implications of this gap in our system have become much clearer since fall 2008 and there is no immediate prospect that the underlying problems will be addressed by the regulatory reform proposals currently on the table.  In fact, our underlying banking system problems are likely to become much worse.

2)      The executives who run large banks are aware that the insolvency of any single big bank, in isolation, could potentially be handled by the government through the same type of FDIC-led receivership process used for regular banks.  However, these executives also know that if more than one such bank were to fail (i.e., default on its obligations), this could cause massive economic and social disruption across the U.S. and global economy.  The prospect of such disruption, they reason, would induce the government to provide various forms of bailout.  They also invest considerable time and energy into impressing this point onto government officials, in a wide range of interactions.

3)      As an example of the ensuing bailouts, in its latest iteration the current administration has (a) run stress tests in which the stress scenario was not severe, (b) determined that banks are solvent, but some should raise small amounts of capital, (c) at the same time continued to provide large amounts of government subsidy through FDIC-guarantees on bank debt, large credit lines from the Federal Reserve, and cheap capital from the Troubled Assets Relief Program.

4)      The government strategy today is forbearance, as in the early 1980s, in which you wait for the economy to recover by itself and hope that this brings the banks back to financial health.  This is risky because: it may not work (depending on the defaults seen in “toxic” assets); it may lead the banks to engage in undesirable short-term behavior (with either too much or too little credit, depending on how exactly their incentives are distorted); and it rewards banks for previous irresponsible actions (and therefore encourages more of the same in the future).

5)      As a consequence of both this general failure to deal with big bank insolvency and the specific problems induced by current government policy, big bank executives have an incentive to reduce the probability that their bank fails for idiosyncratic reasons but they are much less concerned about their bank failing in a manner that is synchronized with other banks.  These bank executives have a strong incentive to copy the actions and policies of other big banks.

6)      By not changing incentives for powerful bank insiders, we are lining ourselves up for another big “moral hazard trade” – think of this as a bailout by the Federal Reserve of everyone, but especially banks.  Current and future bank executives will take risk again – but next time it will be risk with the public’s money.  A housing bubble led to the current difficulties but the meta-bubble is a rise in financial services as a share of the economy, which has been underway since the 1980s.  In the latest manifestation of the ensuing shift in economic and political power towards the financial sector, an unsustainable “Fed bubble” is potentially underway.  This may lead to outcomes that are considerably worse than what we have seen so far. 

7)      Everyone agrees that insolvent banks are a bad thing.  Since September 2008, we have learned about the additional difficulties that follow when no one knows if banks are insolvent are not. There are many manifestations of this problem, including: illiquid markets for toxic assets; accounting tricks, like the FASB rule change and the preferred-for-common stock conversion; and stress tests that turn out to be not very stressful, with outcomes that are apparently negotiable and mostly about public relations.

8)      There is a striking contrast between how we deal with small/medium-sized banks (using an FDIC intervention) and large banks – only the latter can obtain never ending bailouts.  The solution would be some kind of regulator able to take over any financial institution, but also better ways of measuring asset value, capitalization, etc.  In line with that general approach, Thomas Hoenig has a strong proposal for our current situation, which is to use negotiated conservatorship, as was done with Continental Illinois.  However, even his approach needs to be supplemented with quickly breaking up and selling off troubled banks; this is a daunting administrative task, but better than the alternatives.

9)      The critical weakness in our system is that bank executives get to keep their jobs and their money.  All key insiders should be fired when their banks become insolvent (as part of the government intervention and support process), irrespective of the reason for that insolvency.  They should also be subject to large fines, equal to or in excess of the value of their total compensation while leading the bank that failed.  As things currently stand, powerful insiders have learnt that they can gamble heavily and never lose personally or professionally.

10)  Our national debt will increase substantially as a result of direct bank bailouts and, more importantly, the discretionary fiscal stimulus needed to keep the economy from declining – as well as the standard deficit due to cyclical slowdown (a feature of the “automatic fiscal stabilizers”).  This will constrain our future actions as a nation.  For example, it may limit our options in terms of health care reform, with severe adverse social, economic, and budgetary implications.

11)  The costs to consumers from our broad and deep banking crisis come in many forms.  For example, in a period of financial confusion, it is easier to raise fees on consumers – they will have a harder time switching to other credit companies and many of them need the credit in order to survive.  Supporting consumption is a key part of our economic recovery, but we are letting credit card issuers hit consumers hard; this is evidence of prior uncompetitive behavior (i.e., limiting entry, in order to raise prices later).

The remainder of my testimony summarized the argument from “The Quiet Coup“, as published in The Atlantic.

By Simon Johnson

38 responses to “Consumer Protection When All Else Fails (Written Testimony)

  1. A Somewhat Unified Theory of Political Economy

    WEALTH: There is no such thing as a free lunch. Real wealth only increases with productivity, whatever form that might take.

    SUPPLY&DEMAND: Economics is about individual and collective choices that have behavioral and technical consequences, positive and negative.

    MICRO&MACRO: Individual elements and systems act and interact over time learning and evolving, which can result in sounder and better or weaker and problematic. Markets are not perfect, because we are not. Moreover, no one knows everything and some know more than others.

    DEVELOPMENT: The best long-term economic development plan is the one where governing and regulatory bodies work to provide the most level playing field possible for all. If pursuit of happiness is the goal, wellness and or quality of life indicators are needed.

    IMPLICATIONS: The invisible hand works best in conjunction with the golden rule because the only real and lasting economic gain comes from doing things better, individually and collectively.

  2. re “Special interests are convinced that they can fend off the regulatory challenge, but I find this increasingly unlikely.”

    I must vigorously disagree. Trillions have been spent and yet more trillions committed to propping up these institutions in exactly their current form with modification whatsover, not adopted were even the semblance of the most elementary steps constantly urged by Wall Street on troubled companies, such as cutting back pay and passing the dividend. With such a huge financial and political investment in the status quo ante by two Administrations from two political parties with an “historic” election intervening, how can one assert with a straight face that there any sort of non-cosmetic reform?

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  4. Keep it up Simon! We need voices like yours.

    One question for you – in your post, you say: “The critical weakness in our system is that bank executives get to keep their jobs and their money.”

    Why is this? It does not seem that the lack of accountability is limited only to banks.

    Seems like CEO compensation is a factor in the negative business climate these days, in that vast sums of money are invested in these men with no accountability for their actions. Should CEOs continue to be protected from their own poor decisions that adversely impact the company?

  5. I might add that the bankers did this with other people’s money. Other people who just happen to also be taxpayers. The bankers also used other people’s money to contribute to the reelections of the people you were talking to so the people you were talking to could give the bankers more power to take more of other people’s money to contribute to them to keep them in power so they could give the bankers more power, etc.

  6. Eric Dewey, Portland, Oregon

    Glad to hear you’re hopeful about change, and your post hits dead center.

    I’m not as sanguine as you are – being on the inside of the banking system for 10 years has made me realize how deeply and pervasively the culture of entitlement has rooted in the industry.

    We regularly get prodded to support our “leaders” in their endless lobbying efforts, and those of us who do not participate are increasingly marginalized.

    But I will continue to watch this blog and The Hearing, in the hope that I am wrong about this country’s ability to change…

  7. The financial and economic crisis is not just a case of an economic cycle gone rogue. It is a question of democracy versus plutocracy. This happened before: Roman democracy was crushed by its plutocracy, giving rise to the empire, and its increasing fascism. In Rome, plutocracy had been boosted (indirectly) by Hannibal. This time plutocracy is boosted by the (Democratically Unsupervised) Fractional Reserve Banking system. The Fractional Reserve Banking system allows unelected private individuals to create public money and to allocate it according to their good pleasure. This turns an oligarchy into a reigning plutocracy.

    The democratic solution is to crack down with democratic supervision making bankers into fiduciary agents of the republic.

    Patrice Ayme

    http://patriceayme.wordpress.com/

  8. David Martin

    Thank you for your attempts to bring honesty and commonsense into a world where it does not seem to exist.
    Your opportunity may occur when the present rally dies, as it is surely the result of false accounting and market manipulation with the object of throwing off regulation of bonuses and to raise money from the sale of bank shares.
    If the plunge is as great as I think it will be, that will leave Giethner, Summers and Obama with the rather tricky problem of explaining what has happened to the few trillion dollars so far spent.
    Big fish eat little fish, and so it will surely be a matter of passing the blame down the chain.
    However, the banksters are so deeply tied in with Congress and the Senate that it is difficult to see how effective measures can be taken against them, even if Obama has a Damascene conversion – which in my view since I regard him as an astute politician is at least part of the reason why he has not moved against them, although in that regard his fundamental conservatism also seems important.
    If it is any consolation to American readers corruption and insider dealing is perhaps even more endemic here in the UK.

  9. Simon can’t even string together a coherent argument anymore. First, this is completely false:

    “The executives who run large banks are aware that the insolvency of any single big bank, in isolation, could potentially be handled by the government through the same type of FDIC-led receivership process used for regular banks.”

    No, the failure of a single large bank could NOT be handled with an FDIC-led receivership, and this is precisely the problem. The major banks are all organized as bank holding companies, which aren’t subject to FDIC receivership. (And if you think Thomas Hoenig disputed that statement, then you need to re-read Hoenig’s speeches.) This isn’t a matter of opinion — it’s a statement of fact.

    Second, Simon’s assertion that the adverse scenario in the stress test “was not severe” is ridiculous. The macroeconomic assumptions in stress test — that is, unemployment rate, housing prices — are meaningless, as anyone who has ever been involved in running a stress test could tell you. The loss rates are what matter, and the loss rates in the stress test’s adverse scenario were, in fact, very severe. The only people who care about the macroeconomic assumptions are the pundits who have never run a stress test before in their lives.

    Also, bank examinations have ALWAYS been “negotiable,” in the sense that regulators show the banks the preliminary results and then give the banks an opportunity to respond before reaching their final conclusions. That’s because bank examinations, like stress tests, are incredibly subjective, and reasonable minds can disagree sharply about the results. Pre-release negotiations are standard practice, and claiming that these negotiations are evidence that the stress tests were “mostly about public relations” just shows Simon’s extreme naivete.

    Finally, this is ridiculous, especially for an econ professor:

    “[Bank executives] should also be subject to large fines, equal to or in excess of the value of their total compensation while leading the bank that failed.”

    Yeah, it’s called “limited liability,” and it’s been a foundation of our economy for well over 100 years.

    It’s almost amusing that Simon thinks he’s a centrist technocrat. To be a technocrat, you usually have to have a passing familiarity with the technical details. Simon clearly doesn’t even understand the broad strokes of the US financial system.

  10. I think it’s important to consider that fact that multiple backup systems add complexity and may actually increase the risk of disaster as a result; in this sense, the nuclear power plant analogy is perhaps quite apt.

    Complexity should be avoided as much as possible, not only in financial products but in the agencies that regulate them.

    This should not be construed as a call for weak regulatory institutions, but for strong, simple and transparent ones.

  11. Consumer Financial Products Protection Agency? What consumer are we talking about protecting here? If we are talking about protecting the public from unscrupulous credit card or mortgage lenders, that is all well and good. However, I thought this global financial debacle hinged on Credit Default Obligations (CMOs initially), Credit Derivatives and Credit Default Swaps. The “consumer,” as we generally understand the term, did not participate in these transactions directly. Most of the participants were investment banks, the GSEs, sovereign wealth funds, EZ national banks, insurance companies and some commercial banks. Surely they were not all “unsuspecting customers” as per SJ, who was quoting senior banking execs/officials during his 12/2/08 lecture. These entities all have their own due diligence/risk management departments. Is Congress trying to protect these astute, Harvard-educated whiz kids from themselves? Good luck. The Michael Milkens of the world will run circles around government drones every day of the week. My opinion: this proposed agency is just another opportunity to “make work” for aspiring drones.

  12. “2) The executives who run large banks are aware that the insolvency of any single big bank, in isolation, could potentially be handled by the government through the same type of FDIC-led receivership process used for regular banks. However, these executives also know that if more than one such bank were to fail (i.e., default on its obligations), this could cause massive economic and social disruption across the U.S. and global economy.”

    And because of correlation and cascading liquidity crisis, it is in fact LIKELY that these banks will fail at the same time, leaving the government no other option.

  13. I think you have hit on the right mix here, Pete. Transparency is key for the financial institutions also. I thought Sarbanes-Oxley was supposed to prevent off-the-balance-sheet transactions that led to the crisis, but evidently not.

    Complexity leads to unintended consequences.

  14. I think it’s also important that Congress and the taxpayer is able to understand the key issues, since we are evidently invested.

    Sarbanes-Oxley requires accounting for off-balance-sheet transactions, but did not ban them or regulate leverage. And since very few people (certainly not the politicians and taxpayers) truly understood the risk involved, the oversight was worse than useless. It fostered a sense of security in the face of massive hidden risk.

  15. Earl Killian

    In regard to your points #1 and #6, what is your take on the Stern and Feldman book Too Big to Fail? It tried to propose changes that would allow policymakers to let big banks fail, but it didn’t seem very convincing to me.

  16. DesolationRow

    “Steal a little and they throw you in jail. Steal a lot and they make you king.”

    Hope you small banks have learned your lesson.

  17. Simon Johnson writes “The critical weakness in our system is that bank executives get to keep their jobs and their money. All key insiders should be fired when their banks become insolvent (as part of the government intervention and support process), irrespective of the reason for that insolvency. They should also be subject to large fines, equal to or in excess of the value of their total compensation while leading the bank that failed. As things currently stand, powerful insiders have learnt that they can gamble heavily and never lose personally or professionally.”

    And the same or even more should go for all the regulators… including those who lent support or silence from the International Monetary Fund to a crazy system of risk-weights that even fooled the regulators themselves, and in many and truly scary ways still does.

  18. While all your points are well taken, I am especially interested in point #6. I think this needs to be drilled over and over to Congress (and the public as well) and explained in depth so Congress understands and takes action. In my opinion, repeating the same mistakes (i.e. risks) but with public money, is extremely dangerous. This puts a ticking clock on reform policy.

    I did raise an eyebrow at your comment; “They should also be subject to large fines, equal to or in excess of the value of their total compensation while leading the bank that failed.” Certainly, I think they should have been fired, but I think fined requires criminal prosecution and what actual laws were broken? Are we looking at E&O Insurance for bankers in the future?

    Last, I question how effective another agency is going to be to protect “consumers”. Jessica makes a good point about this. Are sovereign wealth funds and commercial banks the consumer?

  19. One of the things I find very interesting about the economic meltdown is the extent to which large banks have benefitted by buying up or taking over brokerage businesses and other large financial businesses at very cheap prices: BOFA – Merrill/Countrywide, Wells – Wachovia(AGEdwards), Chase – Bear Stearns/WAMU etc. Sure, the crisis has caused some short term problems for large banks, but long term the crisis has only made them much larger and more complex. In turn, now they are even more difficult to wind down (too big to fail) should they create another systemic financial, collapse. Basically this crisis also added speed to large banks circumventing the depression era financial regulations that split banks from brokerage businesses. This in turn created a more complicated, risk-taking organization that is very difficult to regulate…..or takeover should they fail.

    Certainly large bank CEO’s have achieved their dreams by merging all financial services back into the giant banking, supermarket model that brought on the last great depression. And when they mismanage risk again they will provide the knock-out punch to our economy that no amount of government stimulus will allow us to buy our way out of. Of course by then the CEO’s will be floating away in their golden parachutes…another job well done!

    To control these banking behemoths the federal government must first cut off the snake’s head by eliminating campaign donations from financial corporations to Congressmen/women. They also need to limit donations from anyone that works for financial corporations (including their spouses – yes we realize how they like to skirt the rules.) Once financial control of Congress is minimized, we will be more likely to see sensible, impartial legislation to regulate large banking, business practices.

    After minimizing the financial conflict of interest, then Congress could focus on creating sensible regulations for banks/financial businesses. I think a good place to start is to once-again split banks from brokerage businesses. The government had it right after the great depression when they split those 2 types of businesses. Banks should focus on meat and potatoes products: savings/checking, CD’s, mortgages, etc. Banks cannot effectively advise about more complicated financial transactions. This is especially true when the large bank model is to drive out higher priced, more experienced employees and replace them with cheaper, less experienced employees. And better yet – the newer, large bank model where they ship-out their back office support jobs overseas to third world countries: India, the Phillipines, etc.

    After the federal government splits banking and brokerage operations into separate businesses, then the next thing they should do is to break up the large, nationwide banks into smaller, regional banks so they are not too big to fail. That also will help prevent fee/pricing/interest rate collusion between large banks and create a competitive banking market which will benefit the consumer. It also will make the banks easier for the FDIC to oversee and take over if needed.

    After that Congress should focus on beefing up the various federal agencies that regulate our financial businesses. Beef up the FDIC so they can effectively control/monitor complicated financial products that banks use: CDO’s, credit default swaps, etc. And the SEC also needs a complete overhaul in the wake of the Madoff/Stanford scandals. And let’s not forget to regulate how the ratings agencies provide ratings for financial products. Should their business model really be driven by how many products they rate? Especially when their inflated ratings drive those fees/profits? And what about the bond/debt insurance business? Obviously there needs to be more regulation of the AIG’s of the world. And what about the cozy relationships of financial, institution executives and the federal agencies that regulate them? How much in-breeding is acceptable between the financial businesses and the government agencies that oversee them? Now I’m sure there are plenty of other areas left to regulate, but these are a good start.

  20. This is a very good “Unified Theory of Political Economy”

  21. The banks that bought up brokerage houses haven’t fully integrated them yet. It takes a long time, so I don’t see why we can’t force them to keep them separate entities either just operating independently even though part of the same company or operating under some umbrella corp of sorts and then spin them off as a separate entity. The banks that took on the brokerage firms would still have made a nice return on their asset when they sell it off. But the separation of depository banks (boring banking) and brokerage houses needs to be made and the sooner the better/easier.

  22. Mark: ““[Bank executives] should also be subject to large fines, equal to or in excess of the value of their total compensation while leading the bank that failed.”

    Yeah, it’s called “limited liability,” and it’s been a foundation of our economy for well over 100 years.”

    And what is this limited liability balanced by? Limited liability is a way of making others pay for your mistakes. That can be a good thing, but it is not an unalloyed good. Scale matters. When a company is so large that its owners and managers can socialize its risk while remaining insulated through limited liability, that fosters abuse and invites disaster.

  23. Complexity is a particular problem in the realm of credit. Credit is based upon trust, and complexity erodes trust.

  24. A good theory! I hope we can start live and work by these rules.

  25. We need names!!! Of real people!!!

    Whatever it might be high time to put some humans in the front line and disallow all this hiding behind corporate veils turned into cloaks.

    No more credit ratings without the five professionals most responsible for those ratings putting their name on that rating… for better and for worse.

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  27. The holding companies are not the problem. The system-critical banks could be stripped out from those companies, divided into good bank/bad bank, the good bank confiscated (subject to fair compensation, as decided by the public regulator – if the holding company disagrees, it can go to court), and the bad bank with all the toxic, radioactive waste could be dumped on the holding company.

    Then the holding company goes into Ch. 7 like every other insolvent pyramid scam.

    Oh, and the CEOs go with the bad bank. And if they want their bonuses and golden parachutes, they can line up as the most junior creditor of an insolvent holding company.

    Then you start prosecuting. Start with the war crimes trials for Clinton, Cheney and Cheney’s trained monkey. Then you move down to the counterfeiting operation – sorry, “off-balance-sheet-SPVs,” my bad – of Morgan and GoldmanSachs. And when the fatcats and their apparatchiks start crying “limited liability,” you reply “sorry, no points. Limited liability or not, counterfeiting money remains illegal.”

    Finally, you make a campaign finance reform along the lines of the German rules, and impose confiscatory wealth taxes on fortunes in excess of a quarter billion €, in order to kill off the robber barons as a political power factor once and for all.

    Simple.

    – Jake

  28. “1. We need layers of protection against financial excess. Think about the financial system as a nuclear power plant, in which you need independent, redundant back-up systems – so if one “super-regulator” fails we don’t incur another 20-40 percentage points in government debt through direct and indirect bailouts. A consumer financial products protection agency should definitely be part of the package. Update: The Washington Post reports that such an agency is now in the works; this is a big win for Elizabeth Warren, Brad Miller and others.”

    This more than welcome development is long overdue. As badly needed as this is, ideally its creation wouldn’t be tied to continued public outrage and the resulting stoked political indignation and will. Hopefully there is more than enough momentum to get this done and in a manner that ultimately renders our hopes for such an agency rewarded and well spent.

  29. You forgot one:

    THE SPICE MUST FLOW: The backbone infrastructure – railways, the telecom backbone, the payment clearing system, the electrical grid and the water supply cannot be privatized successfully. Because these are system-critical natural monopolies. In other words, privatisation results in less efficiency (if there are multiple operators) or in a single company being able to exercise monopoly power (i.e. hold society to ransom by taking crucial infrastructure hostage).

    – Jake

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