The continuing ability of Big Finance to play our elected representatives, and thus the taxpayer, should surprise no one. This is about organized money against relative diffuse public interests. It’s Mancur Olson’s Logic of Collective Action meets sophisticated media managers with experience in emerging market crises – they know that as long as you can look confident and pump in money, everything turns around and people forget (and then you can re-run the show).
More puzzling is the reluctance of other well-organized interest groups to act against Big Finance. In particular, powerful business groups – like Independent Community Bankers of America – understand very well what happened and the way in which are largest banks were responsible. Yet they refuse to push for regulatory reform, either in broad terms or with regard to consumer protection (e.g., see their policy statements; recent testimony).
Their reasoning is fascinating but completely wrong.
Community bankers have convinced themselves that any new regulatory burden will fall disproportionately on themselves. They are particularly concerned about the consequences of a Consumer Financial Protection Agency (CFPA).
But complexity, disinformation, and ill-treatment of consumers are absolutely not in the interest of community bankers. They mostly engage in simple transparent transactions – the kind that the CFPA would wave through.
How are community bankers helped by consumer rip-offs run by the largest banks? Those schemes undermine consumer purchasing power, destroy confidence, and lead to periodic crises – macroeconomic, regional, and personal. The big banks may renounce such behavior for the future, but anyone in the industry knows that their incentives are quite to the contrary.
But there’s more. The fall-off in consumer spending affects commercial real estate, particularly through its impact on retail space. Community bankers have a major exposure to this sector. This may seem like an indirect mechanism, but the banks know very well what is happening and why.
And that’s not all. The increase in government debt today, taken on as a crisis-fighting measure, means higher taxes for someone tomorrow. Community bankers earn decent incomes and should start putting some of that aside to pay for the misbehavior of big bad banks down the road.
Protecting consumers properly is essential to sustained recovery. It won’t by itself necessarily prevent future crises, but it can limit their impact and their costs. It also tilts the playing field – for once – away from the biggest financial players and towards some of our smaller and better run banks and credit unions.
By Simon Johnson
The Baseline Scenario 
I know several executives at small banks that were flipping subprime mortgages and the like. I think you are being sentimental here.
I agree with the reasoning of this.
But practice isn’t always reasonable, and it’s not irrational for the smaller banks to fear that in practice regulation would be gamed to further empower the big banks while falling on the backs of the smaller.
Look at what’s happening with food safety. The House just passed a bill, HR 2749, which claims to be a “food safety” bill. Politically one would think it’s in response to recent contamination and disease scares.
But here, just as in the case of the banks, the problem lies overwhelmingly with the big corporations, not the small producers. Yet the bill imposes a one-size-fits-all regulatory and fee structure on ALL producers which seems to have been intentionally calibrated to be onerous and perhaps impossible for many smaller producers to comply with, while being nothing more than a mild nuisance to Big Ag.
This is the clear disaster capitalist model, which we know the existing political system will impose everywhere it can.
So if I were a small banker, while I’d agree in theory with this post, I suppose I’d still be leery of what kind of scam Congress and the administration would try to impose in practice.
Yes, Simon, combine Bond Girl and Russ. You’re being sentimental and unrealistic.
Why not, for starters, rescind Gramm-Leach-Bliley
and re-impose Glass-Steagall?
Anything that allows money to bleed through phony
internal corporate walls will be gamed. Any rules
made today will be circumvented tomorrow.
Community banks should strongly support strong walls.
Beautiful Lady in Red (unable to change
her handle…. sigh.)
The fact that “several executives at small banks were flipping subprime mortgages and the like” does not take away one iota from the fact that community bankers are usually in more closer contact with their local communities than big banks who mostly relate to clients by means of monitors and credit ratings. To refer to it as “sentimentality” would seem to be taking the side of the big banks without explaining the reasons for it.
And by the way would the community banks understand how much the regulations coming from Basel had played into the hands of some of the big banks and into the hands of some of the bad practices they would be among the first to be welcoming reform… but starting of course with a full independent review of what was concocted in Basel.
Community bankers, like the rest of us, are frequently irrational. Many of these bankers love to feel that they, along with the mega banks, are part of ‘the establishment’. This little bit of identity politics keeps community bankers, and many other provincials, firmly in line.
Stay tuned for future Bank Failure Fridays, then.
I would be the first to say that Big Finance has behaved destructively and that there needs to be major change. But I think pretending like everyone else in the world (consumers, small banks, etc.) did not participate is a major credibility-killer that will detract from arguments for reform. We have a cultural problem here.
Of course many participated, though foremost the regulators themselves, when they concocted that crazy notion that the capital requirements of a bank should be based exclusively on a loosely defined default risk as measured by some few human fallible credit rating agencies.
And also what reforms do you feel are needed for the regulators to catch a Madoff ? That any regulator who takes upon himself the responsibility of watching out over a Madoff and misses it so completely should be forced to pay his last single cent as a fine? I do not think these are the type of regulations regulators are thinking of.
Yes that type of “poor fourth line descendent of a rich aristocratic family complex” is indeed frequently present, but it has a lot to do with the incentives. The local communities need to set up their Jimmy Stewart awards for their most community responsible banker if they are going to get something more out of them just like you reward a good teacher.
We don’t reward good teachers.
There are two problems here: 1) the way risk is framed, as you pointed out, and the fact that some transactions that should not be permissible are, and 2) the fact that regulators have nothing at stake in their work and are easily captured by the relationships they find most appealing (Big Finance).
The first one is easier to solve than the second. I would start by replacing the current risk-weighted capital requirements with regular stress tests and require reserves for some derivatives transactions. The second is tricky. A sort-of-serious suggestion would be to replace the regulatory structure with a public-private partnership with incentives for identifying infractions. I can think of dozens of problems with this, but the current system is a complete joke.
Who would be the — private partner — in a public-private partnership with incentives for indentifying infractions?
A private company. Like I said, I can think of many problems here :)
I agree with StatsGuy that for oversight to be effective, the person in an oversight role has to be independent if not slightly antagonistic to the entities over which it has oversight. For an industry as… resourceful… as the financial sector, I am not sure how to craft a government agency that will actually behave that way.
Another major problem is sophistication. Unless they are persuaded by romantic notions of making a difference in this world, there is very little reason for the people capable of understanding the more complex financial instruments and how to model them to go to work in government. A company with an incentive to understand these things would invest in such knowledge.
Most government agencies are run by political appointees anyway, and I suspect these people are well aware of the consequences of being good at their job.
At any rate, just throwing an idea out there.
Well you should! Just as you should reward good regulators… which obviously means rewarding them for much more than just helping to avoid a crisis!
Bon Girl if “the current system is a joke” I assume that you would agree that even no system at all could be better.
Hope I can nest this comment into the thread.
It seems to me a government agency, a private agency or a public-private partnership are all at risk for “regulatory capture”.
What do you know of Eliot Spitzer as regulator and prosecutor and would someone of his toughness and experience be the kind of person to head up this kind of agency? Just a thought. I honestly don’t know that much about him.
Define infraction. Is not giving out a completely wrong credit rating an infraction? And if the credit rating agencies did so is not the ones who committed the original infraction the ones who appointed the credit rating agencies to rate, namely the regulators?
The problem in all of this is that what is ruled as an infraction could de-facto become on its own the greatest infraction!
In my view the current system of, through the minimum capital requirements, placing an extra tax on risk-taking and subsidizing the financing of what seems to be less risky is in fact a super-infraction against common sense and humanity.
Re the saintly local banks, it’s worth remembering that almost every single toxic mortgage written in the last 10 years was written by someone sitting across a table from someone else. (there were some percentage of online transactions, of course).
The vast majority of these people did not work for nor represent BoA, ML, GS, etc. They were small banks, local franchises of mortgage lenders, etc who had as much stake in their local communities as the “Wonderful Life” banks we pretend dot the American landscape.
When the big boys invented a vehicle (MBS) that would gladly suck up any piece of worthless paper they generated, they walked right up to the trough and indulged. The only reason these banks aren’t gone is that they never held the mortgages. MBS did them a huge favor.
“But complexity, disinformation, and ill-treatment of consumers are absolutely not in the interest of community bankers. They mostly engage in simple transparent transactions – the kind that the CFPA would wave through.”
It may be they fear regulatory capture by the large financial organizations, with some justice. It may also be they are more corrupt than you imagine. It could also be group loyalty–the way small business defends large, even as large business destroys small. These things are not rational.
Having regular stress tests would eliminate a portion of the rating agency issue.
Re: Spitzer
I could name a handful of people that are good at enforcement. But enforcement is a stepping stone for them en route to grander political ambitions, and they usually focus their energies on one aspect of the industry (and we really need something that can tackle the whole industry). They create a vacuum when they leave.
Re: Regulatory Capture
That is the idea behind compensating them. The government has taken risks in outsourcing government functions to private enterprise in the past. Defense, for example. And like defense, the confidentiality element would be a limiting factor in competition.
The companies could be outright bribed by the banks. But (snark) if they even have a price, that is already a higher barrier to capture than we have currently.
You cannot structure a regulatory agency around a specific personality.
Absolutely.
Good post, Simon, and some very good comments, particularly from Bond Girl, who is exactly right when she says we have a culture problem here.
I don’t think you’re being sentimental, Simon – but as someone who’s worked in compliance in both small and large banks over the past 10 years, I think you may have underestimated the effect of the big banks lowering their standards.
Relevant to this conversation is the fact that, in order to compete with the big banks, small banks and credit unions have also had to increasingly lower their standards – because the consumer will no longer wait for their lenders to take the prudent steps that used to be common.
Over the past 5 years it became essential to be able to give an immediate credit decision, or the consumer could walk one block down the street and get their loan immediately. This has now begun to change, but the effect has been that, in order to survive, more and more community banks and credit unions have stuck their necks into the noose of fast credit and low standards, and the people who implemented those standards have risen to control the community banking organizations.
They are the same type of idiots who are running the big banks, and have the same vested interest in maintaining the status quo as long as possible. They’ll fight CFPA because their interest is really limited to the survival of the culture they’ve inculcated in their own institution, and if they admit that the culture is wrong, they’ll have nowhere to hide from the fury of their boards of directors.
This is a cultural issue, and it will take the retraining of the consumer as well as the banks to get us past it. And the consumer is not going to like it one bit…
Bond Girl you write: “A sort-of-serious suggestion would be to replace the regulatory structure with a public-private partnership with incentives for identifying infractions.
Wall Street has been compared to cowboys in the Wild West where just about anything goes. Seriously, how about this idea: Financial bounty hunters. They get say 60% of the loot they bring in by investigating fraud as out-sourced regulators.
That is hilarious, because I was originally going to liken my suggestion to financial industry bounty hunters, and then decided against it. They could certainly be compensated out of industry fees or recoveries.
You could not have individual “bounty hunters” because of confidentiality rules.
This will not get around the fact that there are many perfectly legal practices that need to be addressed.
Not true. The majority of these mortgages came from not so many mortgage originators who were in business thanks to the credit rating agencies who stamped their AAA on securities that used these mortgages as collaterals and which were fabricated by also quite few Wall Street agents.
To say that all bankers are the same is the same as saying that all working for governments are the same… and though that could be debated I have a hunch some of you would not accept it at face value.
Remember that without the regulators and their credit rating agents not a single of the tens of thousands of extremely badly awarded mortgages would have found a single buyer.
Well, it would be too much work for one bounty hunter. But how about self-organized teams of bounty hunters for competition.
If the United States can hire mercenaries to fight the war in Iraq … why not outsource national defence in the form of outsourced securities regulation?
Where would there be legal barriers? The U.S. is famous for its tort system. Why not tort for abused investors?
Well, we really need an entity that is motivated and not overwhelmed by the enforcement role and is also sophisticated enough to monitor risk in the system.
I think the law of parsimony is useful here. If they are not in favor of the reform, it probably does not suit their financial interests.
Well if we had a planned global economy, none of this would matter, right?
Don’t worry about the slackers and closet totalitarians in such a scenario — it’s all been thought out. No more loans, derivatives, wall street, dark pools, oligarchs, utilitarian poverty… just bungalows and gardens, solarpanels, and factories and service industry humming along at more than full capacity.
In 3 or 4 generations we could turn this ship right around (providing the asteroid doesn’t hit).
— This has been “Your Utopian Moment” for August 3rd, 2009
Bond Girl you write: “like defense, the confidentiality element would be a limiting factor in competition.
I don’t understand what you mean here. Please explain.
Also, yes, apples and oranges are getting mixed up here. The apples being the need for better monitoring of risk, creating better regulation or bringing back older regulations that worked better, for example, the Glass-Seagall Act, or (horrors socialism) a 90% tax bracket for very high income earners perhaps.
Now for the oranges. Free-market proponents are all for privatization and outsourcing to eliminate or reduce government (taxpayer) funding. There is already tort for abused investors. So that part is covered. But there might be something here in the idea of: Financial bounty hunters who get 60% of the loot they bring in by investigating fraud as out-sourced, self-organized, self-financing law enforcement. It might get pretty scary in the right way. But then again this might be grist for a Grisham type novel. I just watch the movie version.
I only meant that such a company would have to have knowledge of banks’ operations that is not public information. Our government (I guess) has such a relationship with the defense companies, which by virtue of their work are exposed to secret information. But it limits the number of players that can be involved.
One of the big problems with bank regulation is that regulators are always ten steps behind. Part of that is capital requirements that invite regulatory arbitrage, which became obvious when things blew up. This ultimately determines the consumer products that are available. But even beyond that, there is not a whole lot of interest in understanding risk. So are they really regulating financial institutions or just hanging around for when someone needs to step in and clean up the mess?
Re: Taxes, etc.
I think if we can change capital requirements and enforcement, these changes will channelize the industry (and compensation) considerably (make it less of a big game of hot potato). I do not think giving consumers the Cliffs Notes version of their mortgage is going to change the industry much.
Thanks Bond Girl,
I guess the Sheriff only gets to swear in and pin the Silver Star on volunteers wearing white hats at the cowboy movies.
Yes, and yes.
And to add a little history, we have adequate cases where Big Banks did stupid things even when there was no implicit government bailout in the offing. Witness the Panic of 1907, which was triggered when big NY banks underwrote a speculative attempt to corner the copper market, which failed.
I don’t know what community banks you have in mind, but there are plenty of tiny banks that behave far more egregiously than anything the money centers would consider.
Banks with $50-75mm in assets spending a couple million on executive payroll. Banks with $200mm in assets going heavily into the CDO world.
You just don’t hear about them because they are tiny, so either they float along under the radar or one Friday night they are gone (ever wonder about some of the absurd recovery ratios put up by the FDIC). They know they have a great Jimmy Stewart reputation, they know that under the status quo no one is wandering the Plains looking too closely in their books, and they have absolutely no desire to let the government stick its nose under their tent.
The big boys have learned to live with the government over the past nine months. They have seen the public outrage, they have dealt with the inspectors, they know that when push comes to shove, the feds blink. Whatever plan gets passed will work for the big guys, or it will be made work. They know that now.
The little guys who watch two or three of their number vanish each week can have no such comfort. They won’t get the Goldman waiver. And they know just how fragile their operations are; for example, true mark-to-market would put them under by the hundreds. Better to make a fuss now, when the government is focused on other things, than let the bill linger until a new crisis gives it urgency.
I want to mention at least two disincentives which may be somewhat operable here. First community banks frequently have linkage to the superbanks. They have non-conflicting programs in many cases and benefit from business referrals from the superbanks who don’t have programs which match customer needs. There is some of this significant symbiosis. Second, may community banks are founded with the hopes of being bought by the superbanks and thus get windfalls for boards and stockholders. There is much to the tiering of the banks that is not readily apparent.
Simon:
This is a matter of Religion. A key tenet of the religion of American management is government non-interference because “Government is part of the problem, not part of the solution.” Another key tenet is managerial solidarity–these (mostly) guys would rather do nothing and watch the economy collapse than support intelligent financial reform. These folks all worship @ the First Church of American Capital!
And it is the fact that many of you find yourselves entrenched in either “Government is part of the problem, not part of the solution” or “Government is never part of the problem, always part of the solution” that is the real source of your problems, since reality is never that black or white.
Simon-The problem your post addresses is really several different issues wrapped together. The first part of the problem is that we don’t have a proper civil service in the United States. One of the “reforms” of the the Reagan era was to triple the number of political appointees in government. The number of direct presidential appointees went from about 1000 to about 3000. These people often had hiring authority themselves so the effect on the federal bureacracy was enormous. This meant that, for example, the head of the Detroit office of the Department of Housing and Urban Development was a political appointee instead of a civil servant. He in turn would hire most of the professional staff including attorneys.
This made it possible for politicians to interfere in regulatory agencies enforcemnt actions in ways that had not been done since the 1930’s. In Texas both Vice President Bush and Speaker Jim Wright would request the transfer of Bank examiners who asked too many questions about questionable practices at savings and loans. Needless to say this contributed to the size of the S&L crisis.
“Regulatory Capture” is not something inevitable, it is the result of how the American political system works. A weak civil service cannot enforce laws impartially because of political pressure. Community bankers can legitimately fear that only politically weaker small banks would really be regulated by a CFPA.
The second part of the problem relates to how politicians run for office. They beg for money, often from the very same big money center banks who have caused this crisis. Even politicians in midwestern states like Minnesota take money from the big money center banks. This causes community bankers to believe that any regulations put in place would probably be designed to protect the big money center banks from competition. I remind that President Roosevelts first attempt at regulation, the NRA was designed to protect large firms by reducing competition.
Additionally small banks often have to deal with big banks. Sometimes not alienating people they do business with is also a factor.
Good regulators are rewarded for their expertise by being hired by banks at much higher pay. Incentive-based compensation is almost completely politically infeasible in the public sector, as we’ve all probably noticed by now. There’s no reason to expect that to change.
All beliefs need to be way stations preliminary to facts and knowledge. The best government is that which does exactly that which it does best and nothing more. (Hello, Pangloss!) But anyone who imagines that government fulfilled its function during the creation of the present financial mess must be experiencing a parallel universe.