Tag Archives: financial regulation

Defending Kickbacks

By James Kwak

The Wall Street Journal reports that the SEC will soon decide (well, sometime this year) whether brokers should be subject to a fiduciary standard in their dealings with clients, as registered financial advisers are today. At present, brokers only need to show that investments they recognize are “suitable” for their clients—roughly speaking, that they are in an appropriate asset class.

Not surprisingly, the brokerage industry is up in arms. They want to be able to push clients into the products for which they receive the highest commissions—a practice that (they say) could be more difficult under a fiduciary standard. According to one lobbyist,

a universal fiduciary standard could end up hurting many investors. Lower- and middle-income investors often turn to brokers who are compensated through product commissions, he says, because such clients are less attractive to financial advisers who are compensated based on a percentage of assets under management. Higher costs could prompt some brokers to drop commission-based accounts in favor of more-lucrative accounts that charge a percentage of assets under management, leaving many lower- and middle-income investors without anyone to turn to for investment advice.”

(That’s a paraphrase by the Journal writer, not a direct quotation.)

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Whiskey Costs Money

By James Kwak

A few days ago I wrote a post that began with New York Fed President William Dudley talking tough about banks: “There is evidence of deep-seated cultural and ethical failures at many large financial institutions.” The thrust of that post was that I’m not very encouraged when regulators talk about culture and the “trust issue” but don’t indicate how they are going to actually affect industry behavior.

As they say, talk is cheap, whiskey costs money. What’s more important than what regulators say is what they do—and don’t talk about. Peter Eavis (who wrote the earlier story about bank regulators that my previous post was responding to) wrote a new article detailing how that same William Dudley has delayed the finalization of the supplementary leverage ratio: the backup capital standard that requires banks to maintain capital based on their total assets, not using risk weighting.

Dudley has said, “I do not feel that I in any way hold any allegiance or loyalty to the financial industry whatsoever.” That may be true; he certainly made enough at Goldman that he has no real financial incentive to continue to make nice with Wall Street.* Yet at the same time he appears to be parroting concerns raised by some of the big banks, raising a concern about the leverage rule that Felix Salmon calls “very silly” and that, according to Eavis, the Federal Reserve mother ship in Washington didn’t consider significant.

In the grand scheme of banks and their allies weakening and slowing down new regulation, this is probably not a particularly momentous battle. But it does put things in perspective.

* Of course, we know that among some people (many of whom live in New York and work in finance), no amount of money is ever enough.

You Don’t Say

By James Kwak

Last week Peter Eavis of DealBook highlighted a statement made last year by New York Fed President William Dudley (formerly of Goldman Sachs, then a top lieutenant to Tim Geithner): “There is evidence of deep-seated cultural and ethical failures at many large financial institutions.” There was a point, say in 2008, when many people probably thought that our largest banks were just guilty of shoddy risk management, dubious sales practices, and excessive risk-taking. Since then, we’ve had to add price fixing, money laundering, bribery,  and systematic fraud on the judicial system, among other things. 

Eavis also tried to make something positive out of a couple of other recent comments. Dudley said, “I think that trust issue is of their own doing—they have done it to themselves,” while OCC head Thomas Curry said, “It is not going to work if we approach it from a lawyerly standpoint. It is more like a priest-penitent relationship.”

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The Free Market’s Weak Hand

By James Kwak

“Except where market discipline is undermined by moral hazard, owing, for example, to federal guarantees of private debt, private regulation generally is far better at constraining excessive risk-taking than is government regulation.”

That was Alan Greenspan back in 2003. This is little different from another of his famous maxims, that anti-fraud regulation was unnecessary because the market would not tolerate fraudsters. It is also a key premise of the blame-the-government crowd (Wallison, Pinto, and most of the current Republican Party), which claims that the financial crisis was caused by excessive government intervention in financial markets.

Market discipline clearly failed in the lead-up to the financial crisis. This picture, for example, shows the yield on Citigroup’s subordinate debt, which is supposed to be a channel for market discipline. (The theory is that subordinated debt investors, who suffer losses relatively early, will be especially anxious to monitor their investments.) Note that yields barely budged before 2008—despite the numerous red flags that were clearly visible in 2007 (and the other red flags that were visible in 2006, like the peaking of the housing market).


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The Social Value of Finance

By James Kwak

It’s been more than five years since the peak of the financial crisis, and it seems clear (to me, at least) that not much has changed when it comes to the structure of the financial sector, the existence of too-big-to-fail banks, and the types of activities that they engage in. It’s also clear that the Dodd-Frank Act and its ensuing rulemakings have embodied a technocratic perspective according to which important decisions should be left to experts and made on the grounds of economic efficiency. Even the Consumer Financial Protection Bureau, the Dodd-Frank achievement most beloved of reformers, is essentially dedicated to correcting market failures, which means attempting to achieve the outcomes that would be generated by a perfect market.

The big question is why we went down this route. The traditional explanation, and one that I’ve tended to assume in the past, is that it was a question of political power. Wall Street banks and their lawyers simply want less regulation of their industry, and they feel more comfortable granting actual rulemaking power to regulatory agencies that they feel confident they can dominate through the usual mix of congressional pressure, lobbying, and the revolving door. Given that the Obama administration also wanted to avoid structural reforms and preferred to rely on supposedly expert regulators, the outcome was foreordained.

In a recent (draft) paper, Sabeel Rahman puts forward a different, though not necessarily incompatible explanation. He draws a contrast between a managerial approach to financial regulation, which relies on supposedly depoliticized, expert regulators, and a structural approach, which imposes hard constraints on financial firms. Examples of the latter include the size caps that Simon and I argued for in 13 Bankers and the strict ban on proprietary trading that has been repeatedly watered down in what is now the Volcker Rule.

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That’s the Whole Point

By James Kwak

The Wall Street Journal reports that the federal financial regulators may yet again carve a  loophole in the Volcker Rule. This time, the issue is whether banks subject to the rule’s proprietary trading prohibitions can hold collateralized loan obligations (CLOs)—structured products engineered out of commercial loans, just like good old collateralized debt obligations were engineered out of residential mortgage-backed securities during the last boom.

The reason to prohibit positions in CLOs obvious: it was portfolios of similarly complex, opaque, risky, and illiquid securities that torpedoed Bear Stearns, Lehman, Citigroup, and other megabanks during the financial crisis. The counterargument is one we’ve heard many times before: If banks are forced to sell their CLOs, they will have to do so at a discount, which will “have a material negative impact to our capital base,” in the words of one banker.

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“All You Need for a Financial Crisis . . .

By James Kwak

. . . are excess optimism and Citibank.”

That’s a saying that someone, probably Simon, repeated to me a few years ago. Crash of 1929, Latin American debt crisis, early 1990s real estate crash (OK, that wasn’t a financial crisis, just a crisis for Citibank), Asian financial crisis of 1997–1998, and, of course, the biggie of 2007–2009: anywhere you look, there’s Citi. Sometimes they’re just in the middle of the profit-seeking pack, but sometimes they play a leading role: for example, the Citicorp-Travelers merger was the final nail in the coffin of the Glass-Steagall Act and the immediate motivation for Gramm-Leach-Bliley.

Citigroup is also the poster child for one of the key problems with our megabanks: the fact that they are too big to manage and, on top of that, the usual mechanisms that are supposed to ensure half-decent management don’t work. Around 2009, if you were to describe the leading characters in the TBTF parade, they were JPMorgan, the last man standing (not so much anymore); Goldman, the sharks who bet on the collapse; Bank of America, the ego-driven empire-builder; and Citi, the incompetent (“I’m still dancing”) fools.

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The Wall Street Takeover, Part 2

By James Kwak

Five years later, and things seem marginally better in some areas (the CFPB exists), significantly worse in others (LIBOR, money laundering, London Whale, etc.). There has been some debate recently about whether we have a safer financial system today than before Lehman collapsed. But the fundamental issue, as Simon and I discussed in 13 Bankers, is whether our political system will put the interests of society at large ahead of the interests of large financial institutions. On that score, there is little to be encouraged about.

In 2002, Art Wilmarth wrote a mammoth (262 pages) article titled “The Transformation of the U.S. Financial Services Industry, 1975–2000.” In that article, he identified many of the key trends in the financial sector—consolidation, deregulation, breakdown of Glass-Steagall, complex products, increased risk-taking—that would not only produce a financial crisis but make it so destabilizing for the economy later in the decade. Now he has written a shorter (164 pages) article, “Turning a Blind Eye: Why Washington Keeps Giving into Wall Street,” on the key question: why our government doesn’t do anything about it, even after the financial crisis.

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Regulators Repeat Exactly What They Did During the Last Housing Boom

By James Kwak

The Dodd-Frank Act was supposed to require securitizers to retain 5 percent of the credit risk of the mortgage-backed securities that they issued, in order to reduce the risk of a repeat of the last housing bubble. Today, the federal financial regulators said, “Whatever,” and ignored that requirement. In particular, they created an exemption that would have covered at least 98 percent of all mortgages issued last year.

Why? Because

“adding additional layers of regulation would have contracted credit for first time home buyers and borrowers without large down payments, and prevented private capital from entering the market.”

That’s according to the head of the Mortgage Bankers Association.

This is the exact same argument that was made in favor of deregulation during the two decades prior to the last financial crisis, without the slightest hint of irony. It’s further proof that everyone has either forgotten that the financial crisis happened or is pretending that it didn’t happen because, well, maybe it won’t happen again?

Even leaving aside the specific merits of this decision, the worrying thing is that the intellectual, regulatory, and political climate seems to be basically the same as it was in 2004: no one wants to to anything that might be construed as hurting the economy, and no one wants to offend the housing industry.

The Lame “Uncertainty” Defense

By James Kwak

The indefatigable Brad DeLong has devoted his energies to singlehandedly protecting Larry Summers from the Internet (although, he makes pains to say, he likes Janet Yellen almost as much). Although I’m letting most of the Fed chair sideline debate pass me by, DeLong and others have raised one issue that played an important symbolic role in 13 Bankers and, more generally, the historical background to the financial crisis: Brooksley Born’s proposal to think about regulating OTC derivatives in 1998.

For those who don’t know the story, it basically goes like this. Born, as chair of the CFTC, was worried about the risk posed by OTC derivatives, which were effectively unregulated at the time. On May 7, 1998, the CFTC issued a “concept release”  asking for comments about the regulation of OTC derivatives. Summers, then deputy treasury secretary, along with Treasury Secretary Robert Rubin, Fed Chair Alan Greenspan, and SEC Chair Arthur Levitt, opposed Born, and they issued their own press release on the same day opposing the CFTC. Over the next several months they successfully blocked the CFTC from regulating OTC derivatives, convincing Congress to stop the CFTC from moving forward, a position that was enshrined in statute in the Commodity Futures Modernization Act of 2000.

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What Does 9.5% Mean?

By James Kwak

This week, the Federal Reserve approved its final rule setting capital requirements for banks. The rule effectively requires common equity Tier 1 capital of 7 percent of assets (including the “capital conservation buffer”), with a surcharge for systemically important financial institutions that can be as high as 2.5 percent, for a total of 9.5 percent. That sounds like a lot, right?

If it sounds like a lot to you, it’s probably because (a) it’s higher than capital requirements before the financial crisis and (b) the banking lobby has been saying it’s a lot to anyone who will listen. But apart from some people thinking that higher is better and others thinking that lower is better, you rarely get any basis for understanding what the numbers mean.

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Save If Failure Impending

By James Kwak

Yesterday the House Financial Services Committee held a hearing on the too big to fail problem. Ordinarily a hearing includes a couple of witnesses chosen by the majority who say one thing and one or two witnesses chosen by the minority who say exactly the opposite thing. In this, however, it was hard to tell who was chosen by which side (although I can guess), given the extent of the agreement among former Fed bank president Thomas Hoenig, current Fed bank presidents Richard Fisher and Jeffrey Lacker, and former FDIC chair Sheila Bair.

All agreed that the too big to fail problem still exists, five years after the financial crisis, and that it continues to distort the market for financial services. For example, Lacker, who is perhaps the most sanguine about Dodd-Frank (he likes the living will provisions of Title I), said, “Given widespread expectations of support for financially distressed institutions in orderly liquidations, regulators will likely feel forced to provide support simply to avoid the turbulence of disappointing expectations. We appear to have replicated the two mutually reinforcing expectations that define ‘too big to fail.’”

There was disagreement over whether Dodd-Frank, and the Orderly Liquidation Authority regime that it created, would continue the practice of bailing out failing financial institutions, with Bair arguing that Dodd-Frank “abolished” bailouts. Of course, everyone is against bailouts, but at the same time everyone is in favor of protecting the financial system and the economy against disaster.

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New Research in Financial Regulation

By James Kwak

Not surprisingly, there is a great deal of interesting research being done in the area of financial institutions, systemic risk, and regulatory reform. Last week I had the pleasure of attending a workshop for junior law professors held by the Insurance Law Center of the UConn Law School, where I am a professor. The workshop featured a long list of provocative and weighty papers at various stages of completion. Here I just want to point out a few that are fully drafted and available on SSRN.

Robert Weber presented what should be the canonical paper on stress testing as applied to financial institutions, which has been going on for a while but became front-page news in 2009, during the financial crisis. He traces the history of stress testing back to its engineering roots in Renaissance Italy with, perhaps unsurprisingly, Leonardo da Vinci. Weber is critical of box-checking stress testing, but argues that stress testing  can be useful as a way of encouraging or inducing bank executives and risk managers to more closely investigate their assumptions and beliefs and ultimately create a “morality of quantitative skepticism.”

Gallons of ink have been spilled over the Orderly Resolution Authority established in Title II of the Dodd-Frank Act, generally over whether and how it would be used in a crisis. In 13 Bankers, Simon and I expressed skepticism that it would be used, for practical and political reasons. Joshua Mitts’s paper takes the novel approach of looking at how OLA affects managerial incentives in the pre-crisis period, arguing that it encourages bank executives to design their firms in such a way as to maximize the chance of a taxpayer bailout. This would lead them to increase their exposure to other large financial institutions and to increase the correlation of their asset portfolios with those of other large firms.

Mehrsa Baradaran takes a historical view in her paper, which is about the social contract between banks and society as expressed through banking regulation. She begins with the Hamilton-Jefferson debates over banks (which is also where we began 13 Bankers) and covers the history of banking regulation (or non-regulation) up to the 1930s, which represented the most thorough codification of the social contract: the government needs banks, but banks also need the government. The past few decades, however, have seen an erosion of this social contract, giving banks the benefits of government sponsorship and support without the obligations necessary to ensure that they serve societal ends. Baradaran argues that banking regulation should incorporate a robust public benefit test to ensure that banks are in fact helping households, the economy, and society at large.

There are other interesting papers that are sure to come out of this workshop. One small side benefit of the financial crisis has certainly been the increased attention to the financial sector and the risks it presents to the rest of us.

The Politics of Intellectual Fashion

By James Kwak

Update: See bottom of post.

For years now, Anat Admati has been leading the charge for higher capital requirements for banks, especially large banks that benefit from government subsidies, first in a widely cited paper and more recently in her book with Martin Hellwig, The Banker’s New Clothes. Admati’s great service has been clearing the underbrush of misunderstandings and half-truths so that it is possible to have a debate about the benefits of higher capital requirements. Yet even after all this work, the media (and, of course, the banking lobby) continue to repeat claims that are simply false or highly misleading.

In another effort to beat back the tides of ignorance, Admati and Hellwig have put out a new document, “The Parade of the Bankers’ New Clothes Continues,” which catalogs and addresses these claims. In the simply false category, the most common is probably that capital is “set aside”; in fact, banking capital is assets minus liabilities, and the capital requirement places no restrictions on what a bank can do with those assets.

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If the Fed Knows Banks Are Too Big, Why Doesn’t It Make Them Smaller?

By James Kwak

The Federal Reserve is serious—about something.

On May 2, The Wall Street Journal reported that regulators were pushing to require “very large banks to hold higher levels of capital,” including minimum levels of unsecured long-term debt, as part of an effort “to force banks to shrink voluntarily by making it expensive and onerous to be big and complex.” The article quoted Fed Governor Jeremy Stein, who said, “If after some time it has not delivered much of a change in the size and complexity of the largest of banks, one might conclude that the implicit tax was too small, and should be ratcheted up” (emphasis added). 

A few days later, Fed Governor Daniel Tarullo said roughly the same thing (emphasis added):

“‘The important question is not whether capital requirements for large banking firms need to be stronger than those included in Basel III and the agreement on capital surcharges, but how to make them so,’ said Mr. Tarullo, adding later that even with those measures in place it ‘would leave more too-big-to-fail risk than I think is prudent.‘”

Tarullo recommended higher capital requirements and long-term debt requirements for systemically risky financial institutions.

Last week, Governor of Governors Ben Bernanke quoted from the same talking points (emphasis added):

“Mr. Bernanke said the Fed could push banks to maintain a higher leverage ratio, hold certain types of debt favored by regulators, or other steps to give the largest firms a ‘strong incentive to reduce their size, complexity, interconnectedness.’

“The Fed chairman acknowledged growing concerns that some financial companies remain so big and complex the government would have to step in to prevent their collapse and said more needs to be done to eliminate that risk.”

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