Writing in the Washington Post this morning, Tim Geithner and Larry Summers outline a five point plan for dealing with the underlying problems in our financial system, entitled A New Financial Foundation.
The authors are not completely clear on what they think caused the current crisis, but you can back out some points from their reasoning – and the implicit view seems quite at odds with reality.
- Their view: Regulation is overly focused on safety and soundness of individual banks. Reality: There was a complete failure of safety and soundness supervision. This must be fundamental to any financial system – without this, you’ll get mush every time.
- Their view: “A few large institutions can put the entire system at risk,” so we need a system regulator. Reality: you need to control the behavior of large institutions, more than a few of which got us into this mess. If you can’t come up with a proposal to prevent them from taking system-damaging risk (and there is nothing in today’s article about this), then break them up. The article mentions penalties for being large – higher capital and liquidity requirements for larger banks; we’ll see the details in/after Geithner’s speech tomorrow, but I am not holding my breath for anything meaningful.
- Their view: All large firms will be subject to consolidated supervision by the Federal Reserve and there will be a council of supervisors. Reality: we have plenty of layers, up to “tertiary” regulators (and beyond, in some senses) and there is already enough opportunity for regulatory arbitrage. What prevents the biggest banks from capturing or manipulating regulators? There is no mention in today’s document of the extent to which everyone, including the authors, believed in the big banks’ risk management abilities last time – and continue to rely on the advice of their people today.
- Their view: The originator “of a securitization” will be required to “retain a financial interest in its performance.” Reality: It was a big unpleasant shock when everyone realized that Lehman, Bear Stearns, and others had retained a large exposure to dubious financial products, some of which they had issued. We are back to the Greenspan fallacy here – if financial firms have an incentive not to screw up on a massive scale, they won’t.
- Their view: “[T]he administration will offer a stronger framework for consumer and investor protection across the board.” This sounds incredibly vague and may be the worst news today. It looks like they are backing away from the idea of a Financial Products Safety Commission, for example as proposed by Elizabeth Warren.
And of course the complete omissions from this document are breathtaking. No mention of executive compensation or the structure of compenstion within the financial sector. Not even a hint that the complete breakdown of corporate governance at major banks contributed to execessive risk taking. And no notion of regulatory capture-by-crazy-ideas of any kind.
There are a couple of positive notes towards the end. The administration will seek a resolution authority for dealing with failed banks, but we knew this already. And the authors recognize the need to change how financial systems operate around the world; unfortunately, there is zero detail on this crucial point.
Overall, there are no surprises here. Brick by brick, we are building the foundation for the next financial crisis; by all indications, it will be more disruptive and a great deal more damaging than the crisis of 2008-09. But presumably by then the authors will be out of office.
By Simon Johnson
The Baseline Scenario 
Tim Geithner might explain what HIS regulatory role was as head of the Federal Reserve Bank of New York until Obama PROMOTED him late last year. Give more regulatory power to the FED…yeah, that’s the ticket!
Also, Geithner stared into the “vacuum of their eyes” (an old Bob Dylan phrase from “Like A Rolling Stone) when he witnessed the “financial stake” Bear-Stearns, Lehman and others were holding with regard to securitizations they’d originated. Yeah, that was the ticket, too!
Gosh, I wonder why the stock market went up by seven hundred points in the hour after the news was leaked that Obama would be appointing Geithner to his cabinet?
No mention of incentives at all?
I kind of thought the main problem was that everyone — from appraisers to brokers to ratings agencies to banks to investors — were rewarded for doing incredibly stupid things.
This observation, plus “too big to fail is too big to exist”, ought to provide the foundation for any serious attempt at reform.
Oh, well. Maybe next time.
After all the months of putting out fires (fires they stacked the tinder for themselves), this is the best these clowns can come up with?
It doesn’t even come close to telling us how we got here and then it heaps insult after injury by not giving us a path out.
How dare they print this! Who can read this without having a nervous breakdown? Who do they think they’re dealing with? I am just a housewife but I can see that we’re staring into the abyss, and this, this is as useful as throwing a quarter to a guy dying in the street.
Mr. Kwak, I thank you and the other econbloggers who have given me and millions like me (in just a few months) the ability to interpret these edicts from our modern day Oracles as the twaddle they are. Now it is up to us to spread the word as fast as we can.
Sorry, Mr Johnson, I’m thanking the wrong guy!!
The solution for “too big to fail” can *only* be not having any banks too big to fail. This was the situation before the repeal of Glass-Stegal. No matter how good the regulation and the like, the people administering it all are human and political and they will have the inevitable blind spots.
In any complex system, no matter what you do, something unexpected always goes wrong that you didn’t anticipate. Of course, it is rare, one in 40-50 years, and so it easy to fool ourselves that we have got it fixed this time, that our new regulation regime is working and the like. But only a system that is structurally impervious to the failure of any single entity can survive the inevitable random and unexpected event that will attack the system.
I’m of the view that the Fed ought to be confined to a modest role of smoothing market driven changes in money supply and the direction of interest rates. It should have no regulatory responsibilities in the sense of policing bank operations per se. It should not be engaged in making markets in securitized loans or commercial paper. Access to the Discount Window should be reserved for banks. Above all, independent activities of the Fed should not be permitted to substitute for duly authorized fiscal policies when the political will for such fiscal policy is lacking. It should not be possible for commentators to talk about the central bank as a vehicle of economic central planning, as James Grant has done.
I’m also of the view that regulation of that aspect of banking which is engaged in manufacturing and trading of securities, synthetic securities and derivatives needs to left entirely to market forces, with no possibility of government bailout and no supervision. In this arena, regulation creates opportunities to make money via non-compliance, via loopholes, financial innovation and political influence, and is therefore self-defeating.
The limits of effective regulation are operationally imposed by what a team of supervisors can comprehend in a month of on-site examination.
It would be interesting to explore the ways in which consumers might be harnessed to assist in regulation. For example, lower limits on guaranteed deposits combined with a safety rating system might make bank managements more careful.
In regards to point 3, more layers of supervision will add complexity, and with complexity come the opportunity to game the system.
As far as point 4, it’s disappointing that there is not more talk about simply banning most derivatives, or at least regulating them much more strongly. I believe that the complexity and potential for cascading liquidity events which is inherent in the large markets for these instruments greatly outweighs their marginal usefulness for reducing risk.
We all agree (do we not?) that the system needs to be regulated. If we then allow it to become too complex to be understood, we will have no chance of regulating it properly. This seems obvious, but it has not been mentioned by the administration.
I cannot take seriously and banking reform that does not greatly reduce complexity.
There is also no mention of the funny business at Fannie and Freddie which provided the incentives and at times ordered “doing incredibly stupid things”. There is no way to account for the risk of giving trillions in loans to people who can’t afford them.
Your “reality” view of point 4 ignores that the Bear, Lehman etc. were sold worthless securities that may never have been made had originators been required to take a financial interest in the mortgages they were selling.
From the WSJ and Market Ticker:
” the center of the plan, which administration officials are referring to as a “white paper,” is a move to remake powers of the Federal Reserve to oversee the biggest financial players, give the government the power to unwind and break up systemically important companies — much like the Federal Deposit Insurance Corp. does with failed banks — and create a new regulator for consumer-oriented financial products, according to people involved in the process.”
Do we really want to give the same clowns currently screwing up our financial system the power to break up non financial firms? The opportunities for catastrophic abuse would be enormous, and btw this seems to be just another trampling of our constitutional rights by this administration and the current Fed. I don’t believe the tenth amendment comes close to allowing this harebrained scheme.
I don’t see any reason to believe Obama will be out of office by the time of the next crisis. The crises have been coming every six months or so, and I would say the next one is already overdue. I suppose we can hope Geithner and Summers will be out of office by the time it arrives, but it seems more likely they will be fired after the next crisis.
Reading Swagel’s piece “An Insider’s View” a few months ago, I was struck by the complete disconnect between between the US financial regulation community and people (like you, Simon) who have experience regulating and/or cleaning up after crises in other countries.
Is there anyone in this administration who matters that has taken a hard look at what works and doesn’t work elsewhere in the world?
We mean it this time. Really.
Shuffling the regulatory deck = buck passing.
Sure, they’ve looked a banking systems in other countries that came through this crisis in relatively good shape, Canada and Australia for example and noted that they have higher capital reserves and more streamlined regulation. We seem to be getting the firts one right away and the second is certainly part of the long term strategy.
They were a little vague on the specifics but all in all it doesn’t sound so bad to me.
I just read what Geithner and Summers wrote. This page and a half of hooey (hooey is a word chosen for our family viewers), is supposed to make us feel better?? What was the idea of writing this hooey?? A page and a half? A page and a half to explain the causes of the financial crisis and “A New Financial Foundation”??? Wow guys, your middle school teacher would be impressed with your prolific writing gifts. How does this guy Summers get away with this crap??? Every time he makes a mistake he says “Don’t you know my uncle is Paul Samuelson!!” ?? There was only one thing in the whole page and a half of crap that was concrete: RAISING CAPITAL REQUIREMENTS FOR ALL INSTITUTIONS. Only one thing in that mindless drivel.
George Soros has more revolutionary ideas. Soros says “CREDIT DEFAULT SWAPS ARE INSTRUMENTS OF DESTRUCTION WHICH OUGHT TO BE OUTLAWED.” Yes OUTLAWED!! These are the statements we need to hear from Geithner or Ben Bernanke. I don’t even want to hear or read anything Summers has to say.
Let Summers enroll in Uncle Samuelson’s ECON 101 class and learn the definitions of incentives and moral hazard. Or save money and just let him sleep over in the corner during White House meetings. Here is the link to the Reuters article which gives some of Soros thoughts. http://www.reuters.com/article/marketsNews/idUSPEK34367320090612
I’d like to know what qualifies this guy Geithner for the job of fixing our financial system. He sat in the middle of Wall St. in a big plush office with all the perks & a fat salary provided by us for 5 years(as President of the NY Fed no less). And what we were paying him for? To prevent a financial crisis. And what did he accomplish? Zero. Nada. He was either too dumb or too lazy or both to prevent it. So now he’s going to fix it? Lots of luck.
Thank you, Simon.
Big O digs the Double Dip. Maybe his minions miscalculate the timing, and the accrual of mortgage resets will make it W before 2012.
Ardra;
In Canada mortgage insurance is compulsory for LTV over 80%. Also, mortgage interest is not tax deductible, which may be part of the reason that household debt/income ratio in Canada was less than half what it was in the US prior to the crisis.
So where’s the housing market reform? Do they think that Australian and Canadian banking systems can absorb a 30% fall in national residential real estate values? Where’s the policy to encourage household savings?
Neither Canada nor Australia have anything like the “alternative” financing system of the US (or the UK for that matter.) Where’s the ring-fencing of the shadow-banking system? My point is that the analysis of non-US regulatory systems is painfully superficial.
I’m also curious; do you think that the proposed capital requirements and some “streamlined regulation” would be enough to prevent systemic risk if we rerun the same housing price shock? Or that it would be enough to prevent the overvaluation from emerging?
Chas, Geithner once studied Chinese. Obama actually cited the guy’s efforts to learn Chinese as an indication of his worthiness to lead Treasury. By the way I studied Chinese too – ee, ar, san, su, wu …
From Wikipedia –
“In October 2003 at age 42,[15] he was named president of the Federal Reserve Bank of New York.[16] His salary in 2007 was $398,200.[17]”
We paid Geithner enough for him to buy a $1,602,000 house in 2004. He put it on the market for $1,635,000 in Feb. & reduced price to $1,575,00 a few weeks later. Rented it out for $7,500/month.
Not bad for a government job.
Mr. Pete Muldoon (June 15, 2009, 1018 AM) addresses the crisis from the standpoint of the overall system. This system-thinking gives a perspective much needed and overlooked by those who make a list of particular changes, like Mssrs. Summers & Geithner, no matter how valuable those partial changes are.
Mr. Muldoon implies a refreshing question: ‘why not ban derivatives’? We can conceive of a Wall Street 1 which is focussed on what helps the real economy grow: raising investment and working capital for businesses and loans for consumers. Then there is Wall Street 2 which is focussed on speculation, largely for the wealthy and the oligarchic institutions they control. Derivatives and all so-called ‘financial innovations’ are the bets the wealthy place on Wall Street 2.
Following on Mr. Muldoon’s question: why do we need a Wall Street 2? If there is no innovative financial casino, the wealthy might be forced to put their money in the real economy that produces goods and services for the American people and the world.
I agree with your reading of Swagel’s piece, an account which raises concerns on multiple fronts. If there’s someone in touch with the realities of various approaches to resolutions, I think it would be Sheila Bair and her staff at the FDIC.
I think what we are seeing is that the Obama administration does not actually care about changing the financial system. They realize that as long as Americans are not experiencing Great Depression II, the administration can get away with pushing something weak and checking “reform financial system” off their to-do list. The administration is going to throw all of its eggs in the health care basket and everything else will be subject to incremental tweaks smothered in puff.
But not good enough for him to resist cheating on his tax returns! Ugh!
But not good enough to resist the temptation to resist cheating on his taxes! Ugh.
I don’t know if we’ll even get the chance, frankly. Kent Conrad admitted yesterday that the 10 year cost of the stimulus program is north of $9 Trillion. This is driving the bus straight into a brick wall. Perhaps one reason we saw the selloff on Wall Street today. The Chinese and Japanese are reducing their exposure to the dollar at the exact moment we need them the most.
The problem is that Obama’s campaign received its start-up funding from Wall Street. In American politics politics it is considered wrong to bite the hand that feeds you. Much of what Obama is doing is merely a payoff to Wall Street for financing his campaign. This is why we have investment bankers setting economic policy instead of economists.
The investment banking community will never support meaningful reform because they profit from market failure. Much of their wealth comes from misleading the public about asset values.
No we don’t want to give these same clowns any more power!! Denninger is spot on – has been, and I expect he will continue to be.
This whole situation is truly a nightmare for the average jill and joe. Few who could change things give a hoot. Of course, it is not surprising, given where their money comes from — it is all a puppet show. Nausiating.
Wow, that’s an expected cold slap in the face to the taxpayers who elected Obama, whom I still love. But G and S, and probably V, now just a cheerleader, are bought and paid for, just like Congress, and worst of all, their thinking is in line with the very greedy interests that they are tasked with formulating regulation to control.
It is, again, a case of the foxes regulating the foxes that keep the hen house. Oligarchs prevail. Until their are massive public protests, and a determination to reduce the amount of GDP under control of this out-of-control segment of the business community, this kind of smoke and mirror work will persist.
And, we, the public feel a complete lack of control over our elected officials. And, our feeling is borne out by what is transpiring in the Nation’s Capital: nothing meaningful. On the brink of the next G8 conference, and a mere four months from the next G20, the international community is bound to look at what is happening, and lose the rest of any remaining confidence they had in our ability to do what is necessary to get real recovery started. And, they will be right. AND, there are going to be consequences, and hell to pay.
Let’s get out on the streets, like the Iranians are doing. Obama needs to buckle down and provide REAL CHANGE for us. No one else has the necessary popularity to pull this off, but he still does!!
By doing nothing, Obama is actually taking a risky bet on his reelection. If we have a Japanese-style long (unending) recession, it will be very hard for him to get reelected. Unless the Republican candidate is someone really wacky (like Palin).
The bankers have probably convinced him that everything will be all right in 3 years.
Anyhow, he’ll get what he deserves. It would be pretty ironic if the guy who inspired so much hope goes down in history as the Democrats’ Hoover.
Check the last paragraph:
“By restoring the public’s trust in our financial system, the administration’s reforms will allow the financial system to play its most important function: transforming the earnings and savings of workers into the loans that help families buy homes and cars, help parents send kids to college, and help entrepreneurs build their businesses.”
Well, if that’s all the banks are good for, why don’t we turn the banks into regulated public utilities and fire all the CEOs?
Here is my point by point reaction to the Op-Ed, its a bit long to cut and paste in:
http://www.zacks.com/stock/news/21082/Financial+Regulations+Explained
Thanks for your good work. I think it’s important to remember that the issues and major decisions in play are not just technical matters, but moral ones. I live in Brazil. During 40 some years, Brazil suffered under hyperinflation until finally former President Fernando Henrique Cardoso took the necessary painful measures to bring it under control. Prior to his economic plan, there were 5 other band-aid plans that failed. In each case, the politicians and regulators didn’t have the courage to do what was morally right for the future of the nation. I’m deeply concerned, as is everyone writing for this blog, that today’s U.S. leaders are only looking at the technical, short-term fixes and forgetting their moral responsibility to care for future generations even if that means making hard sacrifices today.
Actually, the insurance on high ratio mortgages provided by the CMHC is a perfect example of a simple regulatory measure that protects both banks and consumers. Some markets in Canada did see housing bubbles but what they didn’t see was the same rate of foreclosure and their real estate market is already starting to rebound. By the way sub-prime mortgages are available in Canada but there isn’t as big a market for them. Why so many US borrowers fell into that category in the first place is something that should be discussed more.
Banks in Canada are large, complex and systemically important institutions run by over paid executives just like the ones in the US. They also took a huge hit from the collapse of the CDS market but they’ve been able to write down those losses and move on. Has it hurt their balance sheets? Yes. Has it bought them to the brink of insolvency? No. Not allowing the banks to leverage themselves into oblivion seems like a no-brainer to me.
I don’t think complicated structures for executive compensation will keep the bankers honest. Good oversight will.
“We are back to the Greenspan fallacy here – if financial firms have an incentive not to screw up on a massive scale, they won’t.”
Yes. Regulation by incentive does not get the job done.
Pete Muldoon: “As far as point 4, it’s disappointing that there is not more talk about simply banning most derivatives, or at least regulating them much more strongly.”
Yes. New financial instruments should be treated like designer drugs, regulated upon creation. They may help to avoid or mitigate risk, but, like drugs, they may reduce responsibility at the same time. Also like drugs, they may have unintended consequences.
Yes!
But presumably by then the authors will be out of office.
and by which time they will have been able to arrange that their lives and futures will be ass nearly completely insulated from the consequences of their deeds as the huge piles of money the intend to make–like their guru, Baba Rubin–in speculation can make them.
Wow, give the Federal Reserve so much more power. Unlimited power to print money, to set interest rates, set reserve requirements, and now to regulate the whole crony financial outfit. And the Fed is not even a government agency, and accountable to no one including Congress!!
This is what happen when those who created the problem are charged to ‘solve’ the problem.
There can only be one reason for this proposal – both Geithner and Summers want Bernanke’s job! More powerful than the president. While Greenspan almost busted up the USA, the new Fed chair with super powers can truly finish the job!!
Breadth-taking. Yes, I can’t breath …
“the wealthy might be forced to put their money in the real economy”
Or put another way, give back the money they took in the first place with tax cuts from their cronies.
“The administration is going to throw all of its eggs in the health care basket”
If “throw all their eggs” means not even bothering to send Rahm to whip for Public Option, then yeah …
http://oxdown.firedoglake.com/diary/5810
we’ll be able to see this mess clearer in september…