The coming months will tell if the Volcker Rule and the prohibition on banks getting even larger will turn out to be substance or mere spin. I’m finally getting around to reading the transcript of the pre-announcement media briefing and I found a few things that were worth a smile.
1. On the cap on a single institution’s share of liabilities: “The 10 percent cap on insured deposits exists in current law. It was put in place in 1994. And what we’re saying is that deposit cap has served or country well.” Um, then why did you waive it for JPMorgan Chase, Bank of America, and Wells Fargo?
From Economics of Contempt (hat tip Brad DeLong):
“The single best thing we could do for financial reform: Triple the budgets of all financial regulatory agencies. Immediately. Regulators are woefully understaffed; this is fact.”
I’m not sure about “single best,” but otherwise dead on. The agencies that are self-funding out of their businesses (banking for the Federal Reserve, insurance for the FDIC) have been less bad than the ones that are not (OCC, OTS).
Last week, Ryan Grim and Arthur Delaney wrote a story for the Huffington Post about the difficulty of getting substantive reform through the House Financial Services Committee. They focus on two main things. First, because a seat on the committee is valuable for fund-raising purposes, the Democratic House leadership seems to have stacked it with vulnerable freshman and sophomore representatives from Republican-leaning districts, meaning there are a lot of Democrats who are either personally inclined to vote with the financial services industry or feel a lot of political pressure to do so. Second, a lot of committee staffers end up switching sides to work as banking industry lobbyists, and some of them then come back to be committee staffers, raising the usual questions about the revolving door. Barney Frank comes off as something of a hero; the idea is that Frank and his senior staffers are so smart and skilled that they can get effective legislation through despite the cards being stacked against them.
The financial reform bill that passed the House recently is full of surprises, not all of them bad. A contact pointed me toward an amendment introduced in committee by Brad Miler and Ed Perlmutter; it’s number 61 on this list. Basically, the amendment gives the Federal Reserve (“Board” in the text refers to the Board of Governors of the Fed) the power to prohibit a financial institution from engaging in proprietary trading not only if it decides that proprietary trading threatens of the soundness of the institution itself, but also if the Board of Governors decides that it threatens the financial stability of the country.
While this may seem overzealous, the point is to prevent a large financial institution with a government guarantee (of any kind) from putting most of its capital to work on its proprietary trading desks and taking lots of risks that might require a government bailout. The amendment does have exceptions allowing firms to, for example, make a market in securities that they underwrite, so securities underwriting is not in question here.
As you already know if you read the news, the House version of the financial reform bill will probably come to a vote today, and it should have the votes to pass unless the Republicans/conservative Democrats manage to pass a poison pill amendment — like Walt Minnick’s amendment to kill off the CFPA and replace it with a council of regulators. (I’m not making this up.) The bank lobby moderate Democrats did manage to get federal preemption of state laws, which means that states can’t set higher standards than federal regulators and sounds like a bad thing (anyone remember the OTS?), but Mike Konczal says it might not be as bad as it sounds.
To be honest, I’m not sure what’s in this thing at the moment, and who knows how many little loopholes have managed to sneak in, especially when it comes to derivatives regulation. But if it has a meaningful CFPA (which I’m pretty sure it does), it’s a step forward. If it doesn’t break up big banks, it’s not enough.
By James Kwak
The post below, which looks like it could be extremely important, is by Mike Konczal, author of the popular (for those in the know) Rortybomb blog, a previous guest blogger on this site, and now a fellow at the Roosevelt Institute – James
Have lobbyists snuck another major loophole into the OTC Derivatives bill? This week the final touches are being put on Barney Frank’s financial regulation bill – H.R. 4173 – “Wall Street Reform and Consumer Protection Act of 2009.” One of the centerpieces of this reform is Title III: Over-the-Counter Derivatives Markets Act. And one of the goals of this reform would be to get as many derivatives as possible to trade on exchanges.
An initial hurdle for Barney Frank was what to do with an “end-user exemption.” This would exempt certain types of derivative buyers who use derivatives, say corporations hedging interest rate risk without speculating, from the extra scrutiny and regulation that comes with the exchange/clearing system. One of the narratives of financial reform so far has been that this initial end-user exemption was too large a loophole at first, and instead of just handling 10-20% of the market, it would let a large majority of the market sneak through, but ultimately Barney Frank was convinced by consumer groups and people pushing for stronger financial regulation and fixed this issue. See Noah Scheiber here in “Could Wall Street Actually Lose in Congress?” for this story, and it shows up as well in a recent profile of Barney Frank in Newsweek.
Many of us bloggers are better at criticizing than at proposing anything — especially when the world makes it so easy to be a critic. The Epicurean Dealmaker, who has sent the occasional volley of criticism my way (I’m not linking to examples because my ego is too fragile), recently decided to deal with this head-on and wrote a “reformist manifesto,” complete with an epigraph from The Communist Manifesto, with a list of specific proposals.
Basically these include cleaning up the regulatory structure, expanding the scope of regulation (consumer protection, hedge funds), moving “virtually all” OTC derivatives onto exchanges or clearinghouses (I believe that “virtually all” means the currently-proposed exemption for “end-user” hedges would be drastically reduced), and increasing Fed transparency. There is also this one: “Ban political campaign contributions by the financial industry.” I think that would be great, although there is at least one constitutional problem and possibly two there.
There’s nothing on the list that I disagree with.
Now that the financial regulatory reform bills are progressing in both houses of Congress, it means that to really be on top of things, you not only have to read the bills, you have to read the amendments. One example is the Miller-Moore amendment (full text here), which passed the committee 34-32, only to run into criticism from Andrew Ross Sorkin and Yves Smith, among others, as well as defenses by Felix Salmon.
The amendment applies to cases where (a) a systemically important (TBTF) financial institution is taken over by the government and (b) the government has to take a loss on the transaction (that is, the assets cannot be liquidated for enough to cover the secured creditors and the insured depositors). In those cases, it says that the receiver can choose to treat up to 20% of a secured debt as unsecured. (A mortgage is an example of secured debt; if you can’t pay off your mortgage, the bank gets the house instead. For financial institutions, we are largely talking about repos — transactions where Bank A sells securities to Bank B and promises to buy them back later, which is effectively a secured loan from Bank B to Bank A — and collateral held provided by Bank A to Bank B when derivatives trades move against Bank A.)
David Moss wrote a good article in Harvard Magazine about systemic risk and regulation; it’s based on an earlier working paper of his. The problem statement is not particularly original, but very clearly put: Depression-era regulation brought an end to recurring financial crises because deposit insurance was combined with strict prudential regulation to guard against moral hazard. Half a century of stability, however, was undermined by a philosophy that regulation was not only unnecessary but harmful in financial markets, at precisely the same time that financial institutions were becoming dramatically larger in proportion to the economy as a whole. For example, as Moss points out, “the assets of the nation’s security brokers and dealers increased from $45 billion (1.6 percent of gross domestic product) in 1980 to $262 billion (4.5 percent of GDP) in 1990 to more than $3 trillion (22 percent of GDP) in 2007.”
The problem today, in Moss’s words, is that “implicit guarantees are particularly dangerous because they are typically open-ended, not always tightly linked to careful risk monitoring (regulation), and almost impossible to eliminate once in place.” The solutions he outlines basically boil down to renewing that tradeoff, so that government guarantees are explicit and financial institutions pay for them through more stringent regulation and cash.
The big news on the regulatory front last week was the Wall Street Journal’s revelation that the Federal Reserve will give its regulators the ability to reject any pay package for any bank employee that encourages excessive risk-taking. The Fed is apparently claiming this authority on the grounds that as a safety-and-soundness regulator, it has the right to prohibit any bank practices that threaten the safety and soundness of the bank. Sounds good to me.
Now, there are certainly reasons to be skeptical, which Yves Smith abundantly outlines. This could be a ploy to gain some populist credentials and head off more Congressional oversight of the Fed. The Fed has been willing to trust banks to tell it what their risks are, so it is not equipped to identify compensation packages that create excessive risk. TheFed will be looking (according to the WSJ) for outliers among the group of the top 25 banks – so as long as all 25 banks are engaged in the same silly compensation practice, the Fed will let it go.
Satyajit Das, who knows more about derivatives than I know about anything, has a guest post on naked capitalism about derivatives regulation. The quick summary? Don’t bet on it.
“‘Holy water’, ‘hosanna’s’ or other utterances (based on particular religious convictions) will be sprinkled or said in the form of initiatives to improve disclosure, increase capital and a new centralised counterparty (‘CCP’) to reduce the risk of a major dealer failing. Fundamental issues – the use for derivative for speculation, mis-selling of instruments to less sophisticated market participants, complexity, valuation problems – will not be substantively addressed.”
To be clear, I favor the Consumer Financial Protection Agency. I favor it because I think it will be good for consumers. I also like to think that it will be good for small banks relative to big banks. My main argument for this is that should not harm the main competitive advantages of smaller banks, which should be customer service and local underwriting. But I’m still in favor of the CFPA even if it doesn’t help small banks.
John Pottow (hat tip Mike Konczal) agrees on the small bank point. His main argument is that the CFPA should lower fixed regulatory costs by making it easier to get approval for basic products. He also adds this point:
“The current credit market, with its indecipherable multi-page contracts, is not competitive. Actually, that’s not true: It’s perniciously competitive — the competition focuses on better hiding fees in small print. Burying terms in legal documents is an activity where larger banks again hold the advantage. By contrast, a true plain vanilla market would remove the obfuscation and refocus the competition on price. Once more, smaller lenders would benefit from this increased transparency and leveled playing field.”
Everyone is writing a Lehman anniversary post these days, and ours is up as our weekly Washington Post column. Our topic is the many forms of moral hazard involved in the banking business these days – for employees, shareholders, and creditors – and whether or not the proposed regulatory reforms will be up to the task of dealing with the problem.
By James Kwak
This week in the WaPo column we are switching from health care back to financial regulatory reform. Our column summarizes and comments on Tim Geithner’s recent white paper on capital requirements. The paper makes a lot of points that are good – more capital is better, higher quality capital is better, risk weighting of assets should reflect risks accurately, and so on. But in this form the principles, while we agree with them, are too uncontroversial to have much in the way of teeth. Ultimately what will matter are the numbers – how much more capital will Tier 1 systemically important financial institutions have to hold – and how hard the administration will fight for real reform. One rule of thumb: if the banking lobby isn’t bitterly against it, it’s probably not enough.
By James Kwak
Elizabeth Warren has a new op-ed at New Deal 2.0 arguing for, surprise, the Consumer Financial Protection Agency, but this time with a different emphasis – non-bank lenders.
The opponents of the CFPA – not only banks, but the head of just about every current financial regulatory agency – argue that consumer protection should be combined with prudential regulation, so that one agency should be both making sure that a bank doesn’t collapse and that it isn’t abusing its customers. Many people have pointed out the flaws with this argument: first, consumer protection invariably slips down on the priority list; second, regulators become hesitant to crack down on abusive practices because those abusive practices generate the profits that make the bank “healthy” to begin with.