Tag Archives: financial regulation

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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