Tag Archives: financial regulation

Why Regulation Goes Astray

By James Kwak

The Harvard Law Review recently published a multi-book review by Adam Levitin, the go-to guy for congressional testimony on toxic mortgages, illegal foreclosures, and homeowner relief (or, rather, the failure of the administration to provide any). It’s a tough genre: Levitin had to write something coherent about six very different books by Bernanke, Bair, Barofsky, Blinder, Connaughton, and Admati and Hellwig, whose sole point of commonality is that they all had something to do with the financial crisis. I don’t agree with all the aspects of his discussions of each individual book, but I think Levitin did a good job using the books as a starting point for a discussion of the incentives problem in financial regulation: the problem that regulators have stronger incentives to favor the industry than to defend the public interest.

HLR asked me to write an online “response,” which in some ways is an even less appetizing prospect—writing something interesting about something someone else (whom I generally agree with) wrote about six other things by different people. On the other hand, they only wanted 2,000 words, so I said yes.

My response focuses on a separate reason that regulation can be captured by industry: ideology. This is something that Levitin does discuss in the body of his article, but I think is not directly addressed by his proposed solutions. If you want to read more, you can download it from SSRN or read it at the HLR site.

Is Credit Suisse Really in Jail?

By James Kwak

Credit Suisse’s guilty plea to a charge of tax fraud seems to be a major step forward for a Justice Department that was satisfied both before and after the financial crisis with toothless deferred prosecution agreements and large-sounding fines that were easily absorbed as a cost of doing business. A criminal conviction certainly sounds good, and I agree that it’s better than not a criminal conviction. But what does it mean at the end of the day?

Most obviously, no one will go to jail because of the conviction (although several Credit Suisse individuals are separately being investigated or prosecuted). And for Credit Suisse, business will go on as usual, minus some tax fraud—that’s what the CEO said. A criminal conviction can be devastating to an individual. But when public officials go out of their way to ensure that a conviction has as little impact as possible on a corporation, it’s not clear how this is better than a deferred prosecution agreement.

Continue reading

Finance and Democracy

By James Kwak

Roger Myerson, he of the 2007 Nobel Prize, wrote a glowing review of The Banker’s New Clothes, by Admati and Hellwig, for the Journal of Economic Perspectives a while back. Considering the reviewer, the journal, and the content of the review (which describes the book as “worthy of such global attention as Keynes’s General Theory received in 1936″), it’s about the highest endorsement you can imagine.

Myerson succinctly summarizes Admati and Hellwig’s key arguments, so if you haven’t read the book it’s a decent place to start. To recap, the central argument is that under Modigliani-Miller, the debt-to-equity ratio doesn’t affect the cost of capital and therefore doesn’t affect banks’ willingness to extend credit; the real-world factors that make Modigliani-Miller untrue (deposit insurance, taxes, etc.) rely on a transfer of value from another party that makes society no better off.

Continue reading

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.)

Continue reading

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.”

Continue reading

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).

 

Screen shot 2014-03-11 at 5.47.38 PM

Continue reading

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.

Continue reading

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.

Continue reading

“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.

Continue reading

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.

Continue reading

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.

Continue reading

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.

Continue reading

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.

Continue reading