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.
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.
“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.
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.
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.
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.
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.
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.
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.”
By James Kwak
Ever since the financial crisis, there has been an on-again, off-again debate over the right model for financial regulation. On the one hand are those who favor simpler rules—such as a simple leverage limit based on total unweighted assets—on the grounds that they are easier to monitor and tougher to game. On the other hand are those who favor complex rules—such as the Dodd-Frank Act, which has so far generated over 8,000 pages of rules—on the grounds that the world is complicated so we need complicated rules. For the most part, this has been a shouting match over broad principles.
A friend sent me Andrew Haldane’s paper from Jackson Hole a couple of weeks ago, “The Dog and the Frisbee.” (The title refers to the ability of a dog—or a child—to catch a frisbee by following a single visual heuristic, ignoring factors such as the rotational speed of the frisbee or wind currents.) Now we have evidence.
By James Kwak
The tragicomic events of the past few months—the London Whale (what are we up to now, $6 billion), Barclays-Libor, HSBC laundering money have prompted renewed interest in better, stronger regulation of the financial sector. Not that it’s going to go anywhere: it’s an election year, the Republicans have a blocking majority in the House and a blocking minority in the Senate, and they are only going to gain Senate seats in November.
But we’ve been here before. Remember the financial crisis? The Obama administration’s response, codified in the Dodd-Frank Act, could be summed up as “better, stronger regulation”—instead of substantive changes to the industry itself. This misses the basic problem with our regulatory structure, as described by John Kay:
“Regulation that is at once extensive and intrusive, yet ineffective and largely captured by financial sector interests.
“Such capture is sometimes crudely corrupt, as in the US where politics is in thrall to Wall Street money. The European position is better described as intellectual capture. Regulators come to see the industry through the eyes of market participants rather than the end users they exist to serve, because market participants are the only source of the detailed information and expertise this type of regulation requires. This complexity has created a financial regulation industry – an army of compliance officers, regulators, consultants and advisers – with a vested interest in the regulation industry’s expansion.”
By James Kwak
It is too obvious to bear saying, but I’ll say it anyway.
At the urging of the administration, Congress passed a financial reform bill this past summer that expanded the theoretical powers of regulators, but also gave those regulators the power to write the rules implementing the bill and then to enforce the rules. The bill’s sponsors fended off efforts to write specific constraints, whether size limits or leverage limits, into the statute. Yet the bill did nothing that I am aware of to ensure that regulators do a better job than they did last time around, unless you count the creation of a standalone consumer protection agency. (Yes, this is a hard problem with no easy solutions, but ignoring it doesn’t make it go away.)
Now we will see the results. Via Mark Thoma, Andrew Leonard provides the money quote, from incoming House Financial Services Committee chair Spencer Bachus: “in Washington, the view is that the banks are to be regulated, and my view is that Washington and the regulators are there to serve the banks.”
Of course, having written a book that argued that politics is more important than economics, this doesn’t surprise me. Nor does the decision by the Financial Crisis Inquiry Commission’s Republican appointees to deny that the shadow banking system even exists, or to write a dissenting “primer” whose only possible motivation can be captured in Barry Ritholtz’s post, “Repeat a Lie Enough Times . . .” But what frustrated me about the administration’s position over the spring and summer was the idea that, despite this basic fact, they marched forward as if government regulation is a purely technocratic problem that can be solved by simply finding smart men and women of integrity and conscientiousness.
By James Kwak
It’s been widely noted that financial reform is now entering a new phase as the action moves from Congress to the regulatory agencies that will write the hundreds of rules necessary to implement the reforms. During the congressional fight, the financial sector had a huge advantage in money and lobbyists, but we had one advantage: the fact that there was (from time to time) a lot of media coverage, and Congressmen care at least a little about public opinion.
In the rule-writing phase, the banks still have a huge advantage in money, lobbyists, and lawyers–and are hiring as many ex-regulators as they can to press their case. As our friend Jennifer Taub writes at The Pareto Commons:
What lies ahead, over the next year and beyond, will require far larger armies of lawyers, economists, finance experts and just plain able bodies and minds to monitor and influence the rulemaking process. Rumor has it that one bank alone plans to set up 100 teams of employees, tasked with particular rule makings. And that is just one bank.
Unfortunately, however, the pressure of the public spotlight is largely off, tilting the battlefield in favor of industry.
The following guest post was contributed by Jennifer S. Taub, a Lecturer and Coordinator of the Business Law Program within the Isenberg School of Management at the University of Massachusetts, Amherst (SSRN page here). Previously, she was an Associate General Counsel for Fidelity Investments in Boston and Assistant Vice President for the Fidelity Fixed Income Funds.
In poetry and politics, metaphor matters. Expect some fighting figures of speech on Thursday, when the conference committee takes up the topic of the Orderly Liquidation Fund or “OLF.” Under the proposed financial reform legislation, the OLF is the facility that would hold the money needed by the FDIC to shut down a systemically important, insolvent financial institution before its failure can contaminate other firms and the broader economy. In other words, one purpose of the resolution authority and OLF is to avoid repeating the disorder and disruption of either the Lehman bankruptcy or the AIG bailout.
To be clear, many question whether regulators will have the courage to invoke this provision and pull the plug on a dying bank. Accordingly, the “prevention” measures under discussion in the legislation are critical — these included the swaps desk spinoff, hard leverage caps on financial firms, regulatory oversight over shadow banks and inclusion of off-balance sheet transactions in capital standards, among others.
One of the hottest debates concerning funding the OLF is over who should pay into the fund and when should they pay. On the question of “who,” the choices have been framed as either industry or taxpayers. And the “when” options are described as in advance of or after a failure. Many, including the House majority in its bill and FDIC Chairman Sheila Bair, support an up-front assessment on industry. Those who oppose an industry pre-fund have tried to damn the OLF as a “bailout fund” and at times the financial reform legislation as a “bailout bill.”
By Jane D’Arista
This guest post is contributed by Jane D’Arista, a research associate at the Political Economy Research Institute at the University of Massachusetts, Amherst, and co-coordinator of its Economists’ Committee for Stable, Accountable, Fair, and Efficient Financial Reform (SAFER). She has taught in graduate economics programs at several universities and served on committee staffs of the U.S. House of Representatives.
Dominated by the world’s largest banks, the over-the-counter (OTC) derivatives market has been expanding since the break-down of the Bretton Woods Agreement in the early 1970s privatized the international monetary system by shifting the payments process from central banks to commercial banks. The proliferation of foreign exchange forwards and swaps that followed set in motion an ever-expanding menu of exotic instruments that reached a nominal value of over $600 trillion by the middle of the current decade. Central banks and financial regulators ignored the implications of the growth of this market and ignored warnings from the Bank for International Settlements (BIS) and the International Monetary Fund (IMF) from 2002 forward that OTC derivatives were at the center of what had become a global casino in which the largest international institutions were the biggest speculators.
The large, international institutions that created the OTC market for foreign exchange forwards and swaps were commercial banks. Following established banking practice, they conducted their derivatives business like portfolio lenders rather than broker/dealers, buying and selling forwards and swaps outside of established markets. But OTC derivatives contracts can’t be classified as assets or liabilities until they are settled and can’t be held on banks’ balance sheets the way loans and deposits are held. Instead, they were booked off balance sheet as contingent liabilities. The market structure that emerged in what came to be the largest market in the global economy was one in which non-tradable contracts were bought by and sold to customers without real time information on volume or pricing or the aggregate positions of the dealers themselves. Moreover, the fact that the contracts were illiquid required constant hedging by dealers that expanded their positions and inflated the size of the market relative to all other national and international financial markets. Meanwhile, the commercial bank dealers’ derivatives business was operating with all the implicit guarantees and subsidies that governments put in place to protect this core financial sector. In 2008, those guarantees became explicit and were exercised.
By James Kwak
So the dust has settled on the Senate bill, and it remains studiously vague about capital requirements — no hard leverage cap, for example. This is what the administration wanted, for two reasons: first, they claim that regulators need ongoing flexibility to modify capital requirements; second, they claim that they need flexibility to negotiate a uniform international agreement.
There is one thing in there that is controversial enough to get the attention of the bank lobbyists: the Collins Amendment, which Mike Konczal has written about here. The main provision of the amendment is that whatever capital requirements apply to insured depositary institutions (banks), they also have to apply to systemically important financial institutions, including at the holding company level.
Sheila Bair of the FDIC is in favor of the amendment, on the argument that bank holding companies should not be able to evade capital requirements that are imposed on their subsidiary insured banks; she doesn’t want to regulate the depositary institutions but have all her work rendered irrelevant because the holding company collapses, triggering a mess of cross-guarantees.
This seems entirely unobjectionable, but as Konczal points out, the real threat to the banks is that it makes it harder for them to engage in financial engineering on the holding company level to evade capital requirements. According to the Wall Street Journal, not only the banks, but also the administration itself is planning to try to kill this amendment (at this point, in conference committee).