Filling the Financial Regulatory Void

This guest post was contributed by Bond Girl, a frequent commenter on this site and author of The Bond Tangent, a very good blog on the esoteric but important world of municipal bonds. I invited her to write it after reading her comments on the topic of financial regulation on this post.

In June, the Obama administration released a report outlining various financial regulatory reforms. The proposed reforms are intended to meet five objectives, essentially: (1) to eliminate regulators’ tunnel vision; (2) to regulate certain financial products and market participants that have so far evaded supervision; (3) to protect consumers from unfair and deceptive sales practices; (4) to provide a framework for responding to financial crises and the failure of major financial institutions; and (5) to promote these efforts globally. Much of the subsequent policy debate has been focused on whether or not the reforms detailed in the report address these objectives. This is a political triumph for the administration because it distracts from the report’s one glaring omission – how to address a culture of sustained affinity between the supervisors and the supervised.

The administration’s proposal appears to portray the financial crisis as nothing more than an accident of reasoning. Because financial regulation in our country evolved in a fragmented manner, regulators’ perceptions of risk were determined by their respective niches when a holistic understanding of risk was required to predict a market failure of this magnitude. It logically follows then that the administration’s preference would be to create a meta-regulator (in this case, by extending the powers of the Federal Reserve and establishing an advisory council) to oversee the supervisory project as a whole and seek out system-wide threats.

While I am sure no one would dispute that a holistic understanding of risk is required to assess financial stability, an even more basic condition of effective regulation is that regulators are motivated to provide honest information about the institutions they supervise. I am not inclined toward conspiracy theories and I obviously do not buy into the caricature of industry players sold by the mainstream media. That said, it is clear that there is a large degree of regulatory capture going on in the financial sector, either directly though professional incest or indirectly through shared intellectual sympathies, which some players have been able to exploit to such an extent that it has reduced standards for the entire industry. It is also clear that this is hardly a novel development.

Financial institutions did not amass trillions of dollars of toxic assets and tangle themselves up in a destructive web of credit derivatives by accident. Financial institutions did not produce and maintain technology allowing them to take advantage of traditional investors by accident. A thief was not able to operate a multi-billion-dollar Ponzi scheme for decades by accident. We are not talking about the occasional rogue trader here who has bribed his compliance officer. Even within the existing regulatory architecture, these activities required a considerable amount of complacency (to be polite) by financial regulators across agencies, over the course of many years, and through many cycles of political appointees from both parties.

I would argue that the fundamental flaw in financial regulation is that it is based on the assumption that regulators are not self-interested individuals like the rest of us. We think about regulation only in terms of how to engineer the incentives of the regulated and ignore the fact that regulators themselves rarely have a stake in doing their job well, which in any other occupation would limit the motivation and types of individuals a position attracts. We all know how the performance of a consistently good trader is rewarded. How is the behavior of a consistently good regulator rewarded?

On the other hand, it is not difficult to see what incentives regulators have to adopt a collaborative posture with the industry (again, to be polite), especially within the organization in which the administration wants to concentrate regulatory responsibilities. The presidents of the Federal Reserve Bank of New York generally come from or end up at investment banks. So many Goldman Sachs employees have held positions in the Treasury and Fed banks in their careers it is a cliché.

Even beyond this, there is probably some value transferred just through the association or intellectual sympathy with industry-types (what Jon Hanson would refer to as “deep capture”) that results in regulators having a bias they do not recognize. If one revisits what Fed officials were saying about financial innovation leading up to the crisis, it is not difficult to see that (1) they thought they were thinking holistically about the risks financial innovation posed, and (2) they were not being intellectually honest in the information they presented about the industry. Even the more prescient regulators figured innovation was a good thing at the time. As a rule, supervisors were disposed to explain away risk by market discipline because they believed themselves to belong to a club of people with special, sophisticated knowledge of the markets, and this is something they value. From the perspective of some in the financial industry, it is something that can be traded.

Sheila Bair’s argument in the regulatory turf war spectacle that is underway would be that these examples illustrate the risk of concentrating supervisory responsibilities in one entity. But it is not a matter of luck whether we get a regulator that is more or less swayable by the industry. By virtue of regulators’ incentives, the financial industry is basically self-regulated.

It is unlikely that consumers will ever hold much influence over the realities of the financial regulatory process because they are not organized in comparison to the financial industry, which concentrates significant resources in the creation of inefficient regulators. By and large, consumers are not well-informed about what they have at stake in the regulatory process and, even if they were, that would not be the sole determinant of how they define themselves politically.

Adding another layer of guards to guard the existing guards ultimately results in an infinite regress. I do not think it is cynical to suggest that, absent an actual paradigm shift with respect to accountability in the financial industry, we are just going to have more of the rent-seeking that has gone on to date and the economic calamities that ensue. For my part, I would propose opening up financial regulation to a small group of social entrepreneurs. Let people establish for-profit companies that can compete for government contracts to stress test the holdings of financial institutions independently and audit their records.

These contracts can be funded by fees charged to the industry that pass through the federal budget and are subject to public scrutiny. Although the fee income that supports these entrepreneurs would derive from industry operations, the social entrepreneurs will not have the power to establish the fees themselves, which should reduce the “shopping” behavior that already exists in financial regulation and with the rating agencies. Some degree of slack will develop as with any form of delegation, but that may be reduced to some extent by adding performance-based metrics to the terms of contracts or by giving the companies a portion of recoveries when they identify instances of fraudulent behavior (similar to what the Internal Revenue Service does with its whistleblower program). Even if social entrepreneurs pull their employees from the same pool of talent as the financial institutions they inspect, the opportunity to profit should make them less sympathetic to industry interests and encourage them to invest in furthering their expertise.

I would hope this is something most people in the financial industry would support. It would be an opportunity to show the industry still cares about actual capitalism.

By Bond Girl

152 thoughts on “Filling the Financial Regulatory Void

  1. These observations are poignant, and the recommendations surely would offer an improvement to the current state of affairs. However, I suspect the capture goes even deeper…

    The capture we witnessed over the last 10+ years was capture of the intellectual paradigm of regulation itself. The activities that furthered banker interests occurred in the light of day, often with the blessing and encouragement of Congress and the President. And, indeed, the Media.

    It was, in short, the utter triumph of Friedmanomic ideology over common sense.

    The intellectual paradigm forms the very groundwork underneath the arguments being made. Those who challenged it were viewed as pariahs – slightly unhinged and certainly unfit for public discourse. Until only a couple years ago, Greenspan was widely hailed a hero. Those who challenged him were kooky, or at worst, un-American.

    Bad incentives and other primitive forms of capture (social circles, revolving door, campaign contributions) were certainly present. But the public (and various Congressional finance committees and the President) saw their activities, and did not challenge – they even encouraged. We can, and have, built institutions with incentives designed to protect ourselves, but these can only hold back the tide of a changing intellectual paradigm for a short time (perhaps a decade or two).

    At root, our defenses against the corruption of financial regulation were ripped down by two decades of Friedmanomic dominance. The belief that government is essentially bad, no matter how well it is implemented, and the markets cannot be wrong. That, furthermore, free markets are right even when they are visibily distorted by gross market imperfections that any layman recognizes.

    That greed _itself_ is good.

    There were solitary souls that protested over the last 2 decades, but they were treated as Pariahs. Those who criticized Wall Street were portrayed by the media as bitter and envious. Desiring to “destroy” wealth only because they did not have it themselves…

    At bottom, Americans may hate Wall Street for its ill-gotten gains, but many of them still worship the success & wealth that bankers have acquired. Even if they acquired it unfairly.

    It was the Friedmanomic intellectual paradigm, and this undercurrent of “greed-is-good” ideology, that JP Dimon tapped so adeptly with his “Do not villify us” argument. This is the real source of capture.

  2. This is a great post, Bond Girl. Thanks to James for asking her to write it and thanks to Bond Girl for sharing her ideas on this.

    I agree that a fair amount of regulatory capture was needed to create a crisis of this magnitude.

    BUT – I cannot understand how we’ve reached a crisis of this magnitude and the only person held accountable for anything is Bernie Madoff. The “accident of reasoning” theory behind the crisis is absurd.

    If current regulators had not been captured, how would these financial businessmen been held accountable for amassing trillions of toxic assets, etc.?

    Are we really in a situation where there were no regulations at all that prohibited the massive accumulation of toxic assets on the books of these businesses? This was viewed as fair and appropriate business dealings?

    Or are there regulations currently on the books (though not enforced) that can be used now by DOJ to hold some of these bankers accountable? Is it really legal to give loans to people who never had any hope of paying them back? Or is just the consumer responsible for that action?

    How, going forward, should bankers who behave so recklessly and trash the economy be held accountable? That’s the key to reform, IMO, – holding people who trash the economy accountable in ways that mean a great deal to them – i.e. throw them in jail or assess huge fines to businesspeople who’ve ripped off others in various business scams.

  3. “At bottom, Americans may hate Wall Street for its ill-gotten gains, but many of them still worship the success & wealth that bankers have acquired. Even if they acquired it unfairly.”

    I personally think hero-worship of Wall Street is limited to those inhabiting a narrow strip of geography that runs from Wall Street over to Washington, DC.

    Not hearing ANY hero worship of the big guys out here in the flyover zone. If you poke hard enough, you’ll find a large class of Americans who are feeling completely disenfranchised from both business and politics – morally and ethically and philosophically.

  4. Good stuff, Bond Girl!

    The idea of private and independent companies responsible for stress testing and risk-auditing of banks is an interesting one. However, we have to be mindful of substantial problems of its own that this approach will create. The key question we will have to ask ourselves is how to avoid problems we have had with private audit companies (Anderson-Enron) and private rating agencies (’nuff said).

    1) If selected by the government, new private stress-testers and risk auditors will have a strong incentive to identify problems even when no problems exist as they will be competing on the basis of “who is more rigorous”. We may thus simply trade “rose-tinted” regulatory glasses for “black-tinted” private glasses. If selected by banks, private stress-testers will have to remain bank-friendly.

    2) While stress-testing trading books consisting of standard products is conceptually straightforward, stress-testing of highly customized products or of loan portfolios is much more complex and requires detailed knowledge of these products and portfolios. Yet it is these products and portfolios, where most of the problems usually hide. Such bank-specific knowledge will have to be developed by private stress-testers over time. To compensate for that, private stress-testers will have to establish long-term relationships with their banks, similar to what audit companies do today. This will be another reason why banks will be shopping for private stress-testers just like companies shop today for audit companies, who in turn have to demonstrate they are reasonable and business-friendly.

  5. The primary mechanism for regulatory capture in the financial industry seems to be the revolving door. The solution is not to privatize that door–the solution is to close it. By barring financial regulators from ever working in the financial industry, those who became regulators would be those whose derive satisfaction not from the maximization of personal wealth, but from the increase of social utility. Such people would look askance at so-called innovation that serves to increase private profit by concealing and socializing risk. They would not be motivated by a desire to curry favor with future colleagues or to create an environment for future exploitation; their concern would be with that from which they derive satisfaction: the study of complex systems and engineering them to produce overall public value.

  6. Thank you for the thoughtful post; you make a nice argument for solving the regulatory capture problem.

    However, I wonder if your proposal to fix the problem doesn’t suffer from exactly the same problem a regulatory capture? Would not these independent firms draw their employees from the same pool that feeds regulators and investment banks? And even if the talent pool are different, is not the chumminess that results part of the problem? For example, how many financial industry journalists, other than Gillian Tett, were able to see the cracks in the pillars of Wall St?

    Part of the problem is very few people are able to see the problems that result from innovation. Perhaps we need to have the financial industry post a bond when they create new products?

  7. With all due respect to Bond Girl, whose writing and analysis I greatly respect, the first response here should be the use of existing laws, rules and regulation, not the invention of new regulation/audit functions.

    Have a look:

    Click to access Unit4NLawofAdministrative.pdf

    If President Obama is not getting the help he needs to enact his reform, he, like TR and FDR before him, has to start banging some skulls together. He does have the power to do so. Likewise, Congress and the Courts. These agencies do not exist in a vacuum.

    “The President appoints agency heads, and can also fire the heads of executive agencies at will. The OMB makes budget recommendations for each fiscal year. And the OMB reviews proposed and final rules prior to their publication in the Federal
    Register. The President also has the power to issue executive orders that limit agency authority. Judicial review has already been discussed; all agency actions are subject to judicial review.

    “Congress exercises its authority over agencies in several ways. There are oversight committees for each agency. These committees can compel agency officials to explain their actions to them. If Congress is particularly upset with an agency’s action it may repeal the agency’s enabling statute. At that point the agency ceases to exist and its employees must look for other work. A less drastic remedy that congress employs is to modify the enabling statute to force the agency to comply with the wishes of Congress. Can can also control agencies through the budget process. Congress may provide no funding for activities that it does not like or it may require that certain monies be spent on projects that it does like. Nominations of all political appointees to agency offices are subject to the advise and consent of the Senate.” (From the above link.)

    We’ve yet to see the skull-banging required to hold bad actors accountable.

  8. I think Bond Girl covered the shopping issue well – fees paid by industry would be channeled through the govt agency, not paid directly to the auditors. The agency, presumably, would have the power to choose which auditor gets used, possibly based on some sort of open bidding process.

    You do raise a good point that deep knowledge of banks is required to perform real stress tests on portfolios. This could be achieved through an institution in which private auditors are awarded 4 year contracts. At the end of which, the contract goes up for open bidding _among the other private agencies_. Thus, no single private auditor can have back to back terms. Knowing that any irregularities will be identified by the firm that takes over in 4 years, any given auditor has strong incentives to avoid being “too nice” to the firm they are auditing.

  9. Why do you people tie yourselves into rhetorical knots to avoid stating the obvious?

    Goldman Sachs and the others “too big to fail” are ripping off the taxpayer and average investor. This is occurring because state power and corporate power have merged. This is not a “conspiracy theory” this is the elephant in the room.

    I will answer the question at the top: because you are afraid of appearing shrill and alienating your Ivy League friends.

  10. Despite the evidence from Enron…World Com…etc to the current mess on Wall Street, it is far easier to go to imprisonment for theft of one cent than for the wide-spread fraud and theft on Wall St. Government has been neutered in its real responsibilities and to save capitalism from its criminal practitioners.

  11. StasGuy – I was referring to selection of the private stress-testers, not payments to them. If a third-party selects/appoints companies to perform ongoing stress-tests, then there could be bias to choose companies with “black-tinted” glasses.

    More importantly: how is this approach fundamentally different from mandatory rotation of resident regulatory teams?

    Why should one think that private companies will be inherently better at stress testing than the government? Yes, there is a problem with regulatory capture today. What will stop those “licensed” private stress-testers from getting “mentally captured” by the industry?

  12. Bond Girl writes:

    “For my part, I would propose opening up financial regulation to a small group of social entrepreneurs. Let people establish for-profit companies that can compete for government contracts to stress test the holdings of financial institutions independently and audit their records.”

    Another commentator (Richard Hoegstegger ?) at a different post has pointed out that in order for regulations to work there needs to be a civil service to administer the regulations. He cites Canada as a country with a civil service that works. He also says the American civil service has been more-or-less gutted beginning with Reagan following administrations.

    He makes a very good point. There can be carefully-considered laws and regulations. But in order for these laws and regulations to be effective there needs to be a — non partisan — civil service to administer and enforce these regulations.

    Bond Girl suggests that financial regulations be outsourced to “a small group of social entrepeneurs”. But I question if they would be sufficient to create the infrastructure and continuity that a civil service can provide.

    In retrospect, civil servants those much maligned government bureaucrats applying carefully-considered laws and regulations, might be that — systemic culture missing, — that could have prevented the financial excesses that lead to a $700 billion taxpayer funded Wall Street bailout.

    Sometimes boring is better.

  13. Anderson – Enron has already been mentioned but I would say that anybody who didn’t see that coming 30 years ago in accounting class was asleep at the switch.

  14. Bond Girl writes “Because financial regulation in our country evolved in a fragmented manner, regulators’ perceptions of risk were determined by their respective niches when a holistic understanding of risk was required to predict a market failure of this magnitude.”

    Yes and no. The above ignores completely that so much of the financial regulation evolved super-concentrated in Basel. It was the Basel Committee´s extremely arbitrary intervention in the risk allocation system and which proved their totally naive misunderstanding of what holistic and systemic risks really signify, that caused the crisis.

    There is no way we will be able to get the world back on the right track, unless we reverse the unjustified risk-adverseness imposed on the world by some baby-boomer wimps in Basel and who want to call it quit on any further development.

    Now those who represent more risk but that anyhow could mean much more for the world are subject to a diabolic squeeze by their regulators just when they least need it.

    And by the way if you really would want to correct much of what is wrong in the financial system in the US you would have to start by a detailed review of what the use of the non-transparent credit scores really signify. They are more designed as an instrument to develop business by having those who should not have to pay high interest rates subsidizes those who should not be given a loan.

    But what I most object to is all over-concentrating on avoiding a crisis and not caring an iota about making the most out of the boom. When I have a hangover the first thing I ask myself is… was it worth it?

    We already have a minimum capital requirements for banks based on risk and so what we need is a set of minimum capital requirements based on purposes so as to find a better place under the sun… though that place might perhaps be easier to find allowing the market to work on its own, without being deviated into the arbitrage of silly arbitrary regulations.

    Has anyone really read what in Basel II… in terms of human wisdom to me it seems to be one of the historical low-points.

  15. The strength of this piece is its well thought-out analysis of what new regulation is being considered. It weak point, its utterly passive acceptance – almost as a fact of life – of the inability of institutional government regulation to come to terms with the criminal collusion of industry lobbyists and politico-regulatory scum. And the suggested remedy:

    “For my part, I would propose opening up financial regulation to a small group of social entrepreneurs.”

    I mean, really. How long must it take for well intentioned people to grasp the fact that intellectualizing the present dilema within the context of the present system IS the problem. Talk about “infinite regress”, here is infinite regress refined to an art form.

    There assuredly will be no solution of our present difficulties short of a root and branch reconstruction of the present system. Ideally, the first steps ought to involve the incarceration and trial of everyone involved in the present criminality, that is to say all those involved in lobbying and the entire “serving” political establishment. The American people need the police, not “social entreprenuers”.

  16. Michael, while the revolving door is certainly one aspect of the problem, from my experience over the past 10 years as a compliance staffer at several banks, which includes 2 very large and two small institutions, is that the primary problem is more akin to StatsGuy’s analysis: the entire concept of regulation has been negated by a worship of free markets.

    In addition, I can say from personal experience that within every bank I’ve worked for, we relied on an utilized the fact that any point raised by our examiners that we did not like could be removed thru one of two methods: by asseritng that we would cease to be competitive if prohibited from the practices in question, or by appealing above the examiner’s head to a regulatory policy-maker.

    Thus, even while the regulators were in place in the govt agencies, we were able to subvert most attempts to maintain the traditional standards of “safety and soundness” (and of consumer compliance).

  17. I have to agree with the “deep capture” concept. The Federal Reserve is no exception. Over the years the Fed has shaded it’s policies to suit the administration in power. The Fed likes to tout it’s independence but Bernanke is very much a team player. There is no shortage of reasons why Bernanke should be replaced: he is a protege of Greenspan – the greatest bubble enabler in modern history; the derivatives debacle happened on his watch – he failed to anticipate the problem even though the Fed has “wide-ranging institutional expertise regarding financial markets and institutions, foreign as well as domestic”, and apparently is not short of funds; he lacks vision – he needs well defined parameters to do his job as exemplified by the March 23, 2009 Fed press release which states that on regulatory reform “the legislation should spell out to the extent possible the expected role of the Federal Reserve “. It’s not as if the derivatives debacle impacted the Fed’s congressional mandate on employment and price stability?

    These reasons are not likely determine Bernanke’s fate which will probably hinge on the balance between the administration’s desire to reestablish the message of change and the fact that Bernanke is a team player in the middle of a financial crisis.

    Replacing Bernanke, though warranted, won’t solve the problem. Furthermore, the proposal to make the Fed a super regulator is a bad idea: it makes it easier for “the administration of the day” to effect policy. It violates the reliable principle of checks and balances, and likely result in less transparency and more secret policy making. Perhaps the Fed’ powers should be reduced. The Fed’s access to enormous funding for financial crisis contains a built -in moral hazard. When a central banker is faced with a financial problem , the typical response is to throw taxpayer money at the problem, and when that fails plan B is to spend even larger amounts. The moral hazard is increased when the administration of the day taps the Fed’s funding powers and does an end run around congressional spending authority.

    A better solution is to remove the risks from the public sector – such as separating investment banking from commercial banking. Let capitalists “swing for the fences” on their own dime, taking losses on the way down. Systematic risks could be monitored . Proposals to increase capital levels will help but as long as private risks are backed directly or indirectly by a certificate of deposit in some FDIC insured account , losses will continue to be socialised.

  18. Bond Girl, superb post – and kudos as always to James for suggesting it.

    While I agree with your points, I think a further development of the paragraph discussing the “fundamental flaw” in regulation would reveal some additional, and very important points.

    For example, you make the valid point that we “ignore the fact that regulators themselves rarely have a stake in doing their job well, which in any other occupation would limit the motivation and types of individuals a position attracts.”

    This analysis could go much deeper – I’ve worked as a compliance officer in large and small financial institutions for the past 10 years, and would submit to you that in addtion to “rarely having a stake” in doing our jobs well, many compliance professionals would be able to relate situations where they have been actively discouraged from doing their jobs well, and a significant number may state that they have been disciplined and/or fired for acting in good faith in asserting the need for stronger compliance controls. A signficant number of these people will not only have changed jobs, they will also have declined to continue in a compliance role, moving instead to a career path that does not pose such challenges to their continued employment.

    Given this environment, while I think your proposal has some merit, my sense is that it may not be sufficient by itself to achieve the necessary changes in corporate behavior.

    As a supplement to your idea, and because part of the problem is that the financial hit imposed by fines under current law to wayward banks is so pitifully small, I’d suggest that we also need a law requiring a fine equal to a percentage (10%?) of total employee compensation from any financial institution deemed “too big to fail” if that institution is found by their regulator to require formal administrative enforcement actions to correct regulatory issues (e.g. Memorandums of Understanding, Cease and Desist orders, Corrective Action Directives, Formal Agreements, and certainly even when such orders are directed against individuals).

    Note that the fine would be paid by the corporation, and is not a clawback of compensation from employees. However, it would also seem appropriate that any C-level executive responsible for oversight of the division/department(s) involved in the problems should also be required by law to repay the corporation for the fine, thus making the shareholders whole for their bad actions.

  19. If these exotic financial instruments created by the financial industry are the primary cause of this calamity, why not simply outlaw them.

    What good have they really done for us. It would appear that they masked static wages, declining income and increasing debt…

    If other countries want to play dynamite, ok, but we should never find ourselves in this situation again…

  20. I know exactly what you are saying (having worked on the other side of things); I was trying not to be too direct in my wording there, and maybe I should have been. As StatsGuy suggested above, it is deeply embedded in our concept of value that the person who is worth more is actually worth more, and that has a very powerful situational translation.

    I like your suggestion a lot. But it is also the things that are wrong in a “soft” way that get me (especially with respect to innovation, which I do not think is inherently a bad thing), and I am not sure how fines would address that logistically. I think what we need are people that are sufficiently motivated and sophisticated to beat financiers at their own game – produce complex, but realistic models, etc. We need people that can handle old school enforcement but can also draw attention to things that the law does not deal with explicitly (new technology, new markets, etc.). The problem is that one does not usually come by that knowledge by being entirely altruistic (although altruism is certainly compatible with social entrepreneurship).

  21. While it may be apparent that the current administration and Congress have the _power_ to implement certain oversight, it’s quite clear that specific agencies do not have the _incentive_ to implement that oversight (particularly when it is unpopular). The question is how to construct institutions that that are incentivized to enforce good regulation (but not incentivized to over-enforce) after the attention of the public/Congress/President shifts to other matters.

  22. Mandatory rotation of _teams_ is much weaker than mandatory rotation of _companies_ for reasons one might expect.

    Also, a federal agenciy would not necessarily choose an auditor based on severity – they could be chosen randomly from a pool, or based on lowest cost in an open-bid structure. The businesses they are auditing also have the right to file grievances or file legal disagreements. The auditing company actually has a lot of incentives to “go along to get along”, subject to not “blowing it”. It’s not clear they are wearing black tinted glasses.

  23. StatsGuy – how does the FDA work to regulate the drug manufacturing industry? It’s a fairly effective and fairly strict regulatory environment – certainly, it is very difficult to bring a new drug to market. Mistakes are made, drugs are recalled. But when big pharma acts up, they get fined a pretty penny.

    That’s what puzzles me about the financial regulatory lapse – it is clearly quite dangerous to the US to have a unregulated financial community, pushing the boundaries of risk in order to make outsized profits. Yet the financial regulators seem literally paralyzed by the idea of implementing any sort of regulatory control on the banks.

    See, as an example, Goldman’s ability to tap into the “permanent liquidity and funding” (Blankfein’s words) that comes with being a bank holding company – yet they’ve somehow – after the crash, no less – negotiated away the need to operate under what was billed as the more stringent regulatory environment that comes with being a bank holding company.

    To me, it seems like our policies have been designed to institutionalize “too big to fail” – and give the massive companies like Goldman eternal liquidity and funding – and let them engage in the highly profitable risky business as usual that they did before the crash.

    Why? It seems criminal, what has happened to our financial system. If the medical community operated like this, there’d be hell to pay. Why do the banks get away with such destruction?

  24. Anne you talk about “pushing the boundaries of risk” but let us not forget that the explosion occurred in what was supposed to be the least risky… assets mortgages houses, country the US and instruments AAAs.

    The implication of the above is that there is a lot of risk in pushing risk-adverseness

  25. I completely agree with your posting, also with your 9:15 am one.

    Only Madoff in jail. Also noteworthy: Madoff himself recently expressed sheer astonishment about the regulators’ inability/unwillingness to get him.

    How is it possible that Lehman Brothers in its last quarterly filing stated a surplus (of some $ 26 billion), while 6 weeks later it tumbled with a $ 100 billion deficit? At least Enron’s accountant (Arthur Anderson) had to close doors after the fraud was revealed. Why are the CEO, CFO, accountant and other players of Lehman Brothers still living the luxury life?

    Why is RICO law not being applied?

    i can tell you that in the 27 EU countries Brussels dictates almost everything, up to the dimensions of cucumbers. Almost everything, as the financial ‘services’ have succeeded in lobbying themselves to be above and beyond regulation.

    So the most urgent question remains: ‘Why do the banks get away with such destruction?’

  26. “I think what we need are people that are sufficiently motivated and sophisticated to beat financiers at their own game – produce complex, but realistic models, etc”

    It feels like there are many people whose careers rely on complexity. Sorry, you may be nice people, but part of what has happened is that folks with great talents for math and the manipulation of symbols have been recruited to work for the dark side. The best and the brightest are able to out-math the lessers and stay one step ahead of the game. It’s a priesthood, and it’s rotten. Make the system simple and you don’t need the thousands of “engineers” to maintain it. Sorry if that threatens your livelihood — maybe you should have directed your talents to a more socially acceptable outlet. (Not pointed at you personally, BG)

  27. Bond Girl
    great to read you in your new “job” – hope it doesn’t remain the only time

    it’s a pity the “deep capture” piece is not online but maybe that kind of language would be beyond me anyway.

    in the meantime I have my own fantasy of what happens to a regulator when he/she enters the halls of wealth. Most people I have experienced react to even innocent display of superior status (wealth elegance worldliness) by adjusting/synchronizing their behaviour, many out of politeness not wanting to give offense by their clumsiness, wrong dress etc. and of course suckers exist also

    one group of people I have met in the 60s and 70s however behaved consistently different – they were the controllers/checkers from the tax office and they sported a kind of roguish I-am-out-to-get-you behaviour when they took “residence” to conduct their audit. They would come in their cheapest suits and enjoy having us girls ask them constantly if they wanted more coffee or a different chair and observed with a certain glee the anxiety spreading with every batch of files and accounts they asked for.
    They managed to look really low on the social ladder even though they were really well paid only their own offices were and are even today outright shabby while ours were all leather and chrome. Also everybody knew that most of them would, once they had gathered enough know-how in sniffing out fraud and simple errors they would quit the state service and become self employed tax consultants cashing in on their well-earned expertise, which was recognized by everybody because had they not proven at companies X,Y and Z that they would find everything. So besides making the money they had jumped a considerable number of steps on the social ladder.

    So to create a scenario where the regulator/supervisor*) would attract similar types of rogues who by feeling ever so slightly humiliated get fired up to get it right and therefore thrive on the put-downs because it adds to their competence and their future role of quite a few steps up the ladder. But what I miss in your proposal is the incentive for a later career where they would be in status the equivalent or even better than those formerly supervised.

    Hope I didn’t write it up too confusing – maybe I have just seen too many movies with lone guys saving whatever had to be saved – but the tax checkers I have seen in action really showed pretty similar behaviours

    *) (small enterprises sounds good but how do you prevent them from growing?)

  28. The people who post on this site really do not see the forest for the trees. Your intellectual machinations are irrelevant. When Paulson saved AIG after letting Lehman crash and burn, the writing was on the wall. When Goldman squirreled away billions in the second quarter they did it with impunity. The gig is up. The fix is in. You are either well connected or you are a dupe. Trying to shove this square peg into the round hole of your middle of the road world view doesn’t change the facts. We are living in a corporate state posing as a democracy. As long as Walmart’s and Costco’s shelves are stocked things will be O.K. After that the demagogues will rule. Sarah Palin in 2012!

  29. Outstanding post Bond Girl. In a perfect world we can all hope that your sensibility and goodwill would be recognized and applied for the greater good of the markets and the people. But this ain’t a perfect world. We witness time and time again illicit and ill-gotten gains devolving with frightening rapidity into outright criminality; capture is a kind term for bribery, collusion, market manipulation, ruthless deception, PONZI scheme’s sold as innovative products, and the predatorclass quickly owning and controlling markets, governments, and regulators and reaping obscene fortunes in the process until the inevitable bursting bubble busts, and there is much wailing and gnashing of teeth. Here it would be nice if only once the fiends and criminals, the snakeoilsalesmen, and fraud who cause and singularly benefit from these crisis were (FOR ONCE HELD ACCOUNTABLE) – but alas the capture is much too deep, and the government and regulators are far too entangled in the tentacles of the predatorclass oligarchs that are the cause, and the ONLY beneficiaries of the bubble/bust models – I say again THE SINGULAR AND ONLY BENEFICIARIES OF THESE BUBBLE/BUST MODELS!!!

    Until and unless these fiends and criminals are held accountable (and really accountable with real long horrorshow jail terms and complete liquidation of their illgotten gains) for thier deceptions, collusion, bribery, PONZI schemes, ruthless greed, heartless disregard for their fellow human beings and CRIMES – there can be NO HOPE for meaningful regulatory reform, and absolutely zero potential for socalled “freemarkets” Freemarkets do not exist. The markets are owned and controlled by the predatorclass oligarchs who are the only entities that benefit from criminal enterprizes that are bubble/bust models and economies.

  30. I hate to be the pessimist here but the “cognitive capture” of regulators seems to be impermeable. Here we are not even a year on the other side of the abyss and regulators and regulated are by all appearances unfazed. The reason the regulatory schemes worked at all was society had been so traumatized by the Depression that the conventional wisdom had changed. Right now it looks like it would take a complete societal collapse to even get the attention of the neolibs and neocons (and even that might not work).

  31. Well as the others have said, this is fabulous contribution from Bond Girl. I just wished that I had the technical competencies to really understand these issues. So it’s natural to me that the one phrase that jumped out was, “By and large, consumers are not well-informed about what they have at stake in the regulatory process ..”

    If one considers how broad and deep are the ways in which finance (in its broadest definition) affects the citizens of so many countries, it is incredible that so little is really understood about even basic concepts.

    I am now ‘retired’ but have been an entrepreneur for the last 30 years and have managed my own investments almost as long. So I think I know more than the average Joe about money, et al.

    But in a debate with Dr Jarrell, in another place, it is clear to me that I don’t _really_ understand even basic ideas such as ‘inflation’ and ‘money growth’.

    So heaven help us all as we are probably unable to exert any sensible political force to bring Wall St., City of London and the rest, to a place which works for the benefit of society, not a few hundred individuals. Piracy is still alive and well!!

    I don’t know the process but I do see the vision. To educate sufficient of the peoples of this great nation so that they can exert a political force to bring about reform.

    It’s naive I know.

  32. P.S.

    I said, “I don’t know the process ..” and pushed the Submit button. Then an idea came …

    Simon, James and all the rest of you peeps that really know about economics/finance/money/risks and more should start a Blog on the subject of Understanding Finance or something similar? It wouldn’t take a lot to make it really high profile.

    Governments aren’t going to teach their peoples so someone else has to do it!

    Teach a man to fish and you feed him for a lifetime.

  33. FDA is a hard model to duplicate in finance – indeed, it was a hard model to implement in the first place (owing much of its endurance to specific individuals and the thalidomide case). It has been routinely challenged by the deregulation crowd, with prominent economists (the _other_ Stigler) contending that the FDA routinely costs US consumers billions of dollars a year and delays critical drug launches unnecessarily.

    Part of FDA’s success has been its ability to respond to criticism with well-considered innovations. Fast track approval processes, for instance, or the orphan drug program (for drugs with very small target populations). But the true core of the system relies on these features:

    1) The FDA approval process is largely independently funded. It draws funds from application fees.

    2) While the FDA retains the right to approve, it relies heavily on an array of federal advisory committees to provide recommendations. It rarely contravenes them. The criteria for approval, and the structure of epidemiological studies, is also created with the advice of committees.

    These committees are required to have open meetings (with some exceptions), and to have balanced membership (though that is debatable, especially in the last administration). In the FDA, members must recuse themselves from votes where they have conflicts of interest.

    The advisory committees provide further insulation for the FDA staff. If a committee of experts votes down a drug, the FDA does not have to defend its decision to deny approval to the drug. No Congressional committee can get huffy at the head of the FDA for denying approval when a committee of experts voted that a drug is unsafe.

    3) A lot must be said for the organizational culture of the FDA, and the professional organization of medicine. Status, in medicine (at least in high powered medicine), is based more on the opinion of peers than monetary income. The professional costs of losing credibility (e.g. the appearance of impartiality) are severe.

    Unlike in finance, few doctors ever hve the opportunity to make so much money in 1 year that it’s worth sacrificing their professional reputation forever.

    Arguably, the people who go into medicine are also simply more altruistic (on average) than those who go into high finance (though James has noted in other posts how that is being challenged by the magnitude of the incentives to make profit by overtreating).

    4) A powerful intellectual paradigm (medical professionalism) that proved resilient against the attacks of Friedmanomics.

    In sum, the FDA regime is one of the few remaining US regulatory institutions that is highly regarded throughout the world. But it’s hard to translate into financial services.

  34. Great post, Bond Girl. Of course, if we had let Goldman and the others get completely wiped out, either the civilized way through a nationalization in which even the most senior bond holders got annihilated, or the law of the jungle way in which we just let them blow up and pensioners as well as investment bankers had to deal with the messy financial and political consequences, then there really would be a lot of self-regulation going on and it would last for several generations.

  35. I’ve read a lot of posts & comments lately but, none have fully & succinctly explained the financial crisis to me. Most have been a lot of esoteric cr_p.

    This link is to Mike Whitney’s post which is the first explanation of the crisis that I would consider adequate.

    The most important thing I learned while working in an oil refinery for 29 years as an engineer & manager was to define a problem thoroughly before trying to solve it. Mike Whitney doesn’t wade into this with Krugman’s ego tripping, verbosity & pontification. His explanation goes to the root of the problem like an arrow to the heart. He succinctly defines the problem.

    The problem is Ben Bernanke.

  36. Assuming that the banksters have people that “get things done” for them, who are these people? In the case of our giant vampire-squid, is it John F.W. Rogers? He’s the only one on the Goldman board who has no bio blurb or photo.

    The ultimate eminence grise? This is the most one seems to be able to learn about him on the internets:

    What is his wife’s relationship with China?

    The others on the GS board are interesting too. James Johnson was going to be Obama’s vetter for health care nominees until people began to ask questions about his relationships with the health care industry. There’s a Swedish guy who has been given awards with very long flowery names, an Indian fellow who watches over the “Princes Trust,” another who seems to be Mr. Chicago, another who sits on the board at Exxon-Mobil, lots of connections with Tsinghua University, Council on Foreign Relations, et cetera. But the most interesting/elusive is this Rogers. What’s his story?

  37. beautiful idea, Paul and yes Bond Girl did a really good job, even I from abroad understand almost all of it

    but the sad fact is that 45 even 40 years ago I could have said that I understand our health insurance system or all the quirks of our income tax laws for employees … today to achieve the same feeling of knowing my way around it would if at all only be possible if I made it a full day job

    I think it probably is due to the technical advance. As a very simple example: in pre-computer times the government had to decide on altered social security contributions deductible from salaries round about June so that there was time to get even the smallest employer acquainted with any changes as of January. Today it may happen that the new figures come out in January because all you have to do is adjust some computer programs, the buttons to be pushed by the accountant remain the same

    in pre-computer times any halfway competent salary accountant knew the different rates of all the different public health insurers by heart … today I doubt if they even know the by now uniform rate for all

    now this seems an insignificant change from the time before IBM offered accounting programs to perform for employers outside their office to today but by now it has developed in a way that all rules or regulations are incorporated in computer programs, no need therefore to know them by heart. And if almost no human brain knows them by heart anymore how then can said brain make quirky associations/connections or even start thinking about absurdities that accumulate because the computer can “work” with much higher complexities than a crowd of salary accountants of very diverse competence could ever be taught. Of course in a lot of ways this is an improvement but it has damaged if not eliminated a lot of gut feeling out of the process for those who operate it. And if you do not have a gut feeling that something is wrong in the first place you cannot become curious and investigate and that applies to all no matter were their place in the hierarchy of any outfit is

    And that leads to the scary part. People I worked with and admired are aware how opaque the system has become to them, they keep an awareness of and alertness to what they know and what they don’t. But a lot of other white collars cannot tolerate this feeling. They have to pretend to others and themselves that they still have the competence coming out of detailed knowledge we had in the old times.

    In one piece by MIchael Lewis? a scene in a conference room was described and though the author didn’t say so I was vividly reminded of a lot of similar situations in which there was a boss who hadn’t taken care to grasp some simple basics/principals but maneuvered to hide it or declared it beneath him or any other of those tactics, i.e. he would never ever go to the mathematicians’ room and say: explain the basics to me

    Maybe it would help if we, the public, could be taught some 10 commandments to be observed by the professional merchant/financier so that we knew when there was a violation and walk away
    – In our merchant law book there is the term “Sorgfalt eines ordentlichen Kaufmanns” = Carefulness of an orderly merchant. The way this “Sorgfalt” was explained to me in school it meant that in his business dealings he had to adhere to stricter rules of business than non-professionals. The expression hasn’t made it into the media in a long time and isn’t known in offices outside maybe law departments anymore at all. I doubt that by now that there even remains a feeling in the population that when acting as a professional somebody should abide by different than the anything goes rules of everyday life.

    So when Gretchen Morgenson of the NYT said round about the middle of last year that one finance outfit didn’t know what was on their books. I went what??? – an accountant knowing what’s in his books is so fundamental to the self-esteem of any accountant I have known, that I became all Oh my, Oh my, this is terrible
    Then I read that the rating agencies were financed by those whose products they rated and I went what??? In a country where every journalist seems to be careful to include in his piece any personal connection he may have to his subject, in a country like that they tolerated a possible conflict of interest like that?

    These are just two examples of what “my” 10 commandments might be about … or 9 or 11 or 12 but not more they must after all be learnable by heart

  38. chas,
    even though I will not read Mike Whitney’s post because I do not believe in any single-reason-explanation however brilliant and to the point

    … when I read at the beginning of it all that Bernanke had studied the Great Depression all his life I became apprehensive because people who know something in theory really really well quite often have a hard time adapting their world view to new data that is fed to them via reality.
    Now I have no way of even guessing if that applies to Bernanke, but this quite commonly occurring piece of “human nature” is what I would be on the look-out for

  39. maybe Mr. Rogers is just someone who prefers the old standards of privacy …

    but this old NYT-piece is quite something, reads exactly like the inbreading going on in the aristocracies everywhere and anywhere

    only “they” do not seem to do it by marrying family members to eachother anymore but by constructing their boards so that their meetings are sure to turn into cosy get-togethers.

  40. Of course he does, Silke. He operates in the shadows. Wonder what the F.W stands for.

    He goes back to the Baker/Eagleburger days and was rumored to have approved some illegal checking into Bill Clinton’s passport activity while he was at the State Department (they apparently blamed and sacked a lower level employee over this).

    He was also a big fan of Robert Zoellick (huge friend of Enron and of Germany and China)who is now head of the World Bank while he was chief of staff for Paulson.

  41. well for a German the first that comes to mind for F.W. would be Friedrich Wilhelm both names very much liked by our Kaisers/Hohenzollerns etc. ;-)

    but William the Conqueror may of course not be forgotten …
    or there was a Friedrich Barbarossa (red beard) said to sit in the depth of the Kyffhäuser mountain awaiting his come-back after having had a deadly accident (drowned) while on a crusade

    let’s hope “they” are not really about to build a new version of a Reich ;-(

  42. Yes, Bond Girl, it is all about motivation. Obviously, any regulator worth their salt will have to have intimate knowledge of the inner workings of the financial market place, AND be motivated to apply appropriate constraints to abuses of the client base. And, it makes sense to have at least part of this job be done by people who are either incredibly bright and ethically constrained, or who are highly motivated by a reward system. As to the first category, I would nominate Elizabeth Warren, who I happen to believe is completely without sin, a sort of governmental Virgin Mary. I would put her in charge of developing a group of top secret, powerful, highly movitated, brilliant investigators who have absolute power to claim access to any company, or any record, and who can work completely independently. They would have oversight by a Congressional committee which is the equivalent of the committee which oversees the CIA. The media would be completely unable to access any of them, and they could be fired for ever speaking to a member of the media or having any relationship with the parties that they investigate. And, this should be coordinated with all developed nations, so that no regulatory international arbitrage could take place. They would be very well paid, and also rewarded for uncovering fraud and abuse.

  43. I refer to Silke´s comment on the lack of understanding. Yes, one of the problems is that most “experts”, and probably most commenting here, have not even taken time out to read what´s in Basel II. They should! It is scary and it should probably be included among the most outstanding examples of intellectual onanism in mankind’s history.

    Even today, years into the crisis I hear “experts” commenting on risk weighted assets without the faintest idea of what that means and much less giving any thought to the fact that if the arbitrary risk weights are used, what comes out on the other side of this sausage machine is probably not a good sausage at all.

    Then we also have that the whole Basel Committee production is a one dimensioned discussion of the risk of defaults without a word about the purpose of our banks.

    I have for years now arguing that if we absolutely have to keep this Basel method we should at least demand that the minimum capital requirement for the banks be calculated using a matrix with on one axis some better defined risk of default weights and on the other axis “societal purpose” weights. Why should bank finance “riskless” but useless or even dangerous projects for the society and not worthier projects even though they carry more risk?

  44. would the adherence to a principle such as this help
    my purpose here is not propaganda for the virtues of us Germans – it just happens so that this is a basic law/constitution which was written only in 1948 under the order of and probably supervision/help by the US, Great-Britain and France and therefore kind of edited by them.)

    2) 1Eigentum verpflichtet.
    2Sein Gebrauch soll zugleich dem Wohle der Allgemeinheit dienen
    my rough translation:
    Property means obligation
    its use shall serve at the same time the well-being of all
    – zugleich is hard to translate but it means that you shall not use your property in a way harmful to “the others” and even make sure that their overall wellbeing profits by its use. To grasp the full implication of this stipulation for everyday life one would probably have to read whole rooms full of books but its wording bears witness of a noble intention whose survival is threatened by Basel II?????

    One example however comes to my mind: we have extensive woods still privately owned by noblemen (Grafen und Fürsten etc. church was “separated” from lots of its lands by Napoleon) in which the public is allowed to wander about within the limits we consider non-damaging to woods
    – as of old the Archbishop of Mainz for example would keep the peasants even from collecting nuts in “his” wood – to be fair he had every right of being fearful that poachers might diminish his hunting prey as the population of the Spessart were desperately poor and remained so no matter how “ant-like” they went about their work

  45. Of course those basic tenets of civilization should be present but the fact is that the Basel Committee could also be seen as someone going out of his domains doing damage on other properties.

    What would the world say if the regulator asked the insurance companies for more capital requirements whenever they insured someone rated as unhealthy? And the unhealthy on top of the higher market costs of insurance now has to pay an additional arbitrage cost imposed by the regulators.

    Want to see what the Joker had to say about the wimps in Basel?

  46. Thank you again. Without this I would never have begun to speculate whether or not the Potsdam Giants inspired the New York Giants.


    “He dictated the manual of Regulations for State Officials, containing 35 chapters and 297 paragraphs in which every public servant in Prussia could find his duties precisely set out. A minister or councillor failing to attend a committee meeting would lose six months’ pay. If he absented himself a second time, he would be discharged from the Royal service.”

    “at his death there was a large surplus in the treasury which was kept rather bizarrely in his basement.”

    “The observation about the power of the pen being mightier than the sword has sometimes been attributed to him. (See as well: “Prussian virtues”.)”

    “Though he was peaceful, he was by no means gentle. His eldest surviving son was Frederick II (Fritz), born in 1712. Frederick William wanted him to become a fine soldier. As a little child Fritz was awakened each morning by the firing of a cannon. At the age of 6 he was given his own regiment of children[citation needed] to drill as cadets, and a year later he was given a miniature arsenal. Fritz was beaten for being thrown off a bolting horse and for wearing gloves in cold weather. Frederick William would frequently mistreat Fritz (he preferred his younger sibling August William). After the prince attempted to flee to England with his tutor, Hans Hermann von Katte, the father had Katte executed before the eyes of the prince, who himself was court-martialed.”

    Had no idea we still had Hohenzollerns running around:,_Prince_of_Prussia

  47. Per
    “basic tenets of civilization”
    can’t have been present if they allowed banks to leverage 50 to 1 as I read Deutsche Bank did at the peak – they are working with other peoples’ money, money taken into trust down to the small savings of the old honest gardener or any other such iconic person and when their scheme blows up they blackmail the government via peddling the destinies of those same iconic “small” persons whose savings they have beforehand with full criminal intent put at risk – though probably not persecutable because “human nature” tends to dare such stuff only after having found a loophole.

  48. Silke “basic tenets of civilization” can’t have been present if they allowed banks to leverage 50 to 1 as I read Deutsche Bank did at the peak.

    Of course not, but worse than that the regulators hid the 50 to 1 leverage through their “risk-weighting” of the assets and so, in those same 50 to 1 leverage days, they could easily have reported it as 10 to 1.

    And no one said a word about what was going on. Which is what really makes me upset when a pseudo-regulator, as anyone working in the IMF really is, and who said not a word about it all now goes out calling the bankers oligarchs, to buy cheap applauds.

    If we do not speak out how on earth are things going to get better?

  49. Uncle Billy Cunctator

    “Had no idea we still had Hohenzollerns running around:”

    we have lots and lots of them on offer*), a former boss of mine of old baltic nobility with a Portuguese name (just to give you an idea how the families spread all over Europe) was friends with a Prussian Prince
    – if you come to northern Germany (Schleswig-Holstein the beautiful landscape is full of impressive Schlösser inhabited by people with very long names
    – somewhere I have heard they were stripped of their titles in the last century but allowed to go on using them as part of their names. Some of them can get quite authoritarian about your getting it right (for example there is a vital difference in status whether you write “von” or “v.” – seriously I swear this is not a joke – in the small village in middle Germany where I used to live there was a Fürstin who seemed a perfectly normal person when I talked to her for a local newspaper, if you were in a shop however and she would enter you would become immediately non-existent to the sales-girl or owner and the Fürstin would be served. She did nothing to discourage such behaviour – as I was interviewing her for the newspaper I did not try how a simple Frau Ysenburg would play out)

    – don’t know if our new minister of economy is closely related but in some way related he most likely is – they all are and they all know eachother and they have their family reunions and some of them are still quite rich – they are by no means as irrelevant as they always like to claim. – and some time ago we had an Otto Graf Lambsdorff as minister of economy and so on and so on

    *) your excerpts sound really funny but poor mistreated Fritz (der Alte Fritz, Friedrich der Große) actually made the first steps that enabled Prussia to become the core of the united Germany of Bismarck’s time (the one who invented German social security) – wish the unity had never happened, made us far too belligerent and murderous – but compared to the absolutism of Louis XIV of France “L’état c’est moi” – I am the state – Fritz’ Ich bin der erste Diener meines Staates – I am first servant to my state – actually was an improvement but one who put the accumulated wealth of his nutty father almost inclusively into warfare.

    The world has always been a nutty place – therefore my only goal is to find out “what is the new ingredient this time around” in which respect is it different this time, if it is …

  50. Per
    I am in no position to judge Mr. Johnson’s former sins or present virtues (except that reading him is a pleasure for a lay-woman)
    What got me initially interested is the image of oligarchic structures being cooked up
    I think it is very likely that that is happening (the widening gap between myself and the rich being an indicator which I first noticed via a personal experience at the end of the 70s) and as I said at another place I am curious whether the world is really as much on a gaga-road as my gut tells me and if it should be so, is there a new ingredient or just business as usual in different clothes.

  51. Silke “is there a new ingredient or just business as usual in different clothes”

    There is definitely a new ingredient and that is the Basel Committee. The way it has been able to garner power in order to impose their subjective and arbitrary views on the world is just astonishing. They are a prime example of how a supposedly global common good is turned into a global common bad.

  52. Per
    in my picture of history even the founding of the UN would not qualify as a new ingredient – maybe Basel would but what event made it possible that whoever participates agreed to a committee with according to you real power to change things. This is something states have always been very reluctant to do, so where does the power originate that made it possible?

    – the printing of the Gutenberg Bible and the consequent spread of literacy for example would qualify as a new ingredient by my standards or
    – the fact that for example India’s population has more than tripled from 350 million at independence in 1947 to more than a billion in 2007 because any bio-connected system for lack of another word that grows at this speed must be under a terrible catastrophe-prone strain – and it has never ever before happened on any scale even close to it

    – like the introduction of the potato probably had a lot to do with the rise of Prussia the fact that now the US agriculture still manages to help feed large parts of the world softens the consequences for now

    but what about employment while contrary to the doubling or tripling of humankind in an incredibly short time there is the question of life financing labour in the age of the computer which eliminates so many former job opportunities to be replaced by probably more McJobs than comparatively well-paid ones

    To the best of my knowledge none of the states with that kind of population growth can provide adequate jobs in even half-way adequate numbers. Even in a shrinking population like Germany unemployment rates among youngsters are unhealthily high. The computer finally gets to fulfill his labour saving purpose projected at the beginning and laughed at for decades by the know-betters.

    Make youngsters feel that society does not really need them and therefore does not want them and you create an ingredient for anger that can erupt at any time should it find a suitable leader.

  53. In general, I wanted to express support for your view that a lot of this goes back to Basel… There are many causes that all aligned, but one of the major “systemic risk enhancers” is the privatization of money-creation (via debt) with the public absorbing downside risk due to the weak capital cushions of banks.

    This is how I explain it to a laymen:

    Imagine I have $100. Now imagine I could turn that into $2500 for a year, and bet it in the stock market. If I get 10% returns (not too hard in a good year) and pay 2% on deposits for net earnings of 8% (the spread), then I just earned $200 on my $100 investment in 1 year! If I lose, I’m out $100, even if the Fed doesn’t rescue me (which it might if I’m too-big-to-fail).

    Banks create money _temporarily_, but interest or other earnings they get on that money is _permanent_, and the leverage ratio is just too dang high.

    Having said that, the tiered approach of Basel makes some basic sense. Without it, banks have little incentive to invest in low-risk/low-yield assets, and the cost of financing AAA bonds (e.g. government debt) rises. This would be very bad for the US and all of EU right now, given high govt. debt/GDP ratios. However,

    1) The capital asset ratios across the board are too low. The amount of capital at risk to absorb losses is too low.

    2) The proportion of debt to cash in the system, overall, is too high – and if we’re going to permanently deleverage we need to permanently expand base money to compensate (or see mass worldwide deflation)

    3) Asset default rates are more highly correlated than anyone will admit, because the statistical models that back-test data pretend we have 50 years of mostly independent data across lots of mostly independent countries. Indeed, this was how the banks argued that the highest traunches of mortgage backed CDOs were secure… If you assume households are Independent and Identically Distributed (IID), the probability of more than 70% of households defaulting out of 1000 when the base % is even 50% nationwide is ridiculously small. Imagine this – flip 1000 fair coins… what is the chance you get 700 or more heads? TINY. Thus, AAA!

    Moreover, ALL asset classes worldwide have become more correlated over time (precisely because of investing models that tried to take advantage of their inverse correlation).

    4) I cannot conceivably understand how anyone could have thought the current mechanism for financing risk ratings (issuers chooses and pays agency) was a good thing. It takes 60 seconds to explain to a laymen, before they’re looking at me in disbelief. The fact that Congress has not taken up this issue is shocking.

  54. Agreed on all points. The point about fines is simply that they are so puny relative to the magnitude of the aggregated risk presented. Using a scale that is directly tied to the size of compeensation in my view creates a relatively direct between the arguably obscene compensation levels and the systemic risks presented by offering such large compensation incentives.

    Also agree that innovation is not the enemy – the idea of securitization is what has led to a lot of the rise in the global economy over the past 10-20 years. The problem IMHO is ultimately that, when things began falling apart, nobody knew who was ultimately holding the bag because the innovators had not built the infrastructure to trace all of the ownership accountabilities. They skipped this because it would have been extremely complex and expensive to do – but I contend that if those linkages had been in place and clearly visible to the regulators before Lehman went down, they might have made a different decision.

    It is a bit idealistic to hope for better people (i.e. more courageous, less subject to herd mentality) to be the regulators – but my sense is that many of those who are currently in place would be much more likely to fill that void if at least the negative incentives, such as poltical manipulation of exam findings and veiled threats of disciplinary action were removed.

    Perhaps what’s also needed is more comprehensive and stronger whistle-blower protections for those whose primary responsibilities include audits and examinations.

  55. Just want to chime in to say that my understanding is that Basel II is being reconsidered – they may not get it to the point where we would all think it’s perfect, but the capital ratios are definitely being rethought.

    Philosophically, it is critical to keep in mind that at bottom all regulations are nothing more than an attempt to rein in human nature at it’s ugliest and most ignorant. Noone that has studied the course of human history should be surprised that all such attempts ultimately break down, no matter how well they may have worked for a time. The period of time between the regulatory reforms after the Great Depression and the current mess are not the norm, they are the anomaly…

  56. Great post! Thanks to James and Simon for publicizing this work by Bond Girl. I’ve not seen any suggestion for solving regulatory capture that comes close to this. If one could get the public’s anger at the financial industry behind such a solution, …..

  57. Here is a link to a CEPR discussion paper on the ratings issue that basically tries to answer the same question [pdf].

    Click to access working_paper_ratings_gci.pdf

    I think the idea is that after the Great Depression, people just saw the rating agencies as having more credibility (and did not question the compensation issue). They were kind of the market discipline approach to addressing the regulatory void at that time. And finance was simple back then.

    The thing about rating agencies now is that they are so embedded in regulation and the market that they can pretty much do whatever they want. I tried to escape the rating agency model here by removing the connection between the financial institution and the companies doing the inspecting/stress testing. The companies do not get to set the price and the financial institution does not get to choose who evaluates them. Any slack in the model would have to come from the government procurement process, but there are ways to get around that (performance metrics, etc.)

    I’m not sure how they are going to address the Basel II capital issue so long as we are relying on financial institutions to explain the risk they are taking. That is not oversight.

  58. Silke, I am not privy to how the Basel committee could grow so powerful. It has been around since about 1974 but it is really in the last decade its powers have exploded. It would sure make for a quite fascinating research. When I was an Executive Director at the World Bank (2002-2004) and criticized what Basel was up to I was never thereafter invited to the debates.

    I fully agree with most of the concerns expressed in your comment and in jest I have expressed and written about: the need for a tax reform that has as a basis the creation of work like putting an extra VAT on a pizza if consumed at home instead of in a restaurant and the need of new courses at the universities that teach youth how to live purposefully unemployed.

    Your “Make youngsters feel that society does not really need them and therefore does not want them and you create an ingredient for anger that can erupt at any time should it find a suitable leader”, gives me recurrent nightmares too. Just think of all young men who stand no chance tin millions to afford forming a family… how will they show their manhood?

    And against this monumental risks what we have are some bank regulators who only worry about avoiding some not so clearly defined default risk and who have appointed some few credit rating agencies as their sentry. Crazy, eh?

  59. for all of you who are into reading page turners in doorstop format a recommendation:
    the post and its comments today made me remember again and again “Buddenbrooks” by Thomas Mann

    – no the book has nothing to do with the high-brow Mann – it is his first when he most of all proved to be a real good story teller aiming at good sales. Actually the book created such a scandal that Lübeck and he had a major fall-out, so there must be a lot of it very close to reality.

    The book tells the stories of the follies of a merchant family through several generations beginning when the family living in Mann’s actual home town Lübeck is still proud of its Hanse-heritage, the pride of all of Lübeck till today, and ending in their overextension. It is a very good yarn to be enjoyed with a glass of wine/beer/whatever on lazy grasshopping summer evenings and leaves one wiser in one’s knowledge of human nature without any ant-worthy achievement whatsoever.

    oops sorry I think the ant-grasshopper-controversy belongs in the section of health care …

  60. StatsGuy says “4) I cannot conceivably understand how anyone could have thought the current mechanism for financing risk ratings (issuers chooses and pays agency) was a good thing. It takes 60 seconds to explain to a laymen before they’re looking at me in disbelief. The fact that Congress has not taken up this issue is shocking.”

    What can I say? In January 2003, before I was censored by an ego there, in a letter published by FT I wrote “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds.”

  61. They did not have the infrastructure to track ownership or any offsetting risk management measures that were taken. Regulators could have aggressively pushed the issue if they wanted to. They just did not want to.

  62. Per
    “I was never thereafter invited to the debates.”
    it always amazes me how the same tactics are applied at all the levels of a hierarchy (true democracy there) and still we from the cubicle let them persuade us again and again that they are our betters, forgetting again and again that they work under the same threats and strains we do

    and thanks for obviously making sense out of my rather garbled comment

    and yes it is completely crazy and very frighteningly so

  63. Regulators could have aggressively pushed the issue if they wanted to.

    did they not want or did they take it for granted that in our age the data would of course be somewhere on some disk and therefore did not ask?

    Of course it is not a sign of competence if the question should never have popped into their mind but it is different from intent.
    Intent would mean collusion/helper or whatever the correct English word for it is

  64. Eric Dewey “that Basel II is being reconsidered”

    Yeah yeah, reconsidered by the same inventors with the same mentality and in the same setting of a mutual admiration club? Even their watchdog the Financial Stability Forum is made up by their clones.

  65. Bond Girl says “The thing about rating agencies now is that they are so embedded in regulation and the market that they can pretty much do whatever they want!

    Absolutely! You just have to read the minimum capital requirements for banks in Basel II, approved by the ministers of the G10 in June 2004, to understand the incredible race that took off with the market chasing, and fabricating, the AAAs.

  66. Just what we need – more open minded citizens. A big fan of esoteric cr_p?

    Rejecting the post out of hand seems kind of shallow.

  67. Stats Guy, You said, “and if we’re going to permanently deleverage we need to permanently expand base money to compensate (or see mass worldwide deflation)”.

    I don’t understand how base money can be permanently expanded without creating more debt.

    Would appreciate your explanation. (And I’m not being smart here, I genuinely don’t understand!)

  68. this sounds weirder and weirder 10 countries unanimously agreeing on something is so unlikely that I immediately guess that this is a feint to get something really important to them of their back or into their state coffers

    the EU could not even get a watered down to almost nothing constitution agreed on
    – the Crusaders/Princes of old could only unite if the prospect of plunder was promising enough – at one point the pope had to let them strip bare Christian but “unfortunately” schismatic Byzantium because Jerusalem was not enticing enough anymore.

    And ten of them nowadays should agree on something without a hefty profit of whatever kind?

  69. Yes Madoff got a sentence of 54.900 days but of these central bank governors and heads of bank supervisory authorities in the Group of Ten (G10) countries that on June 26, 2004 met and endorsed the publication of the International Convergence of Capital Measurement and Capital Standards: a Revised Framework which helped to provoke 50 to 100 times more losses than Madoff, we can´t even get hold of their names.

    And talking about jail, should not those paid to keep an eye on Madoff and the others who empowered the credit rating agencies get a sentence of at least 1 day?

  70. Bond Girl,

    This all sounds great & all. But, I fail to see how you’re ever going to solve anything without naming some names.

  71. Agree completely – My earlier comment:

    “Bond Girl,

    This all sounds great & all. But, I fail to see how you’re ever going to solve anything without naming some names.”

  72. Great analysis, which can be summarized as : The legal charter of the town sheriff is only as good as his integrity.

    How can we make the sheriff accountable? In a small town where everyone knows everyone peer pressure can work. Not so when the sheriff is a faceless administration.

    I’m unconvinced about social entrepreneurs though.

    Some people are hardwired with integrity and a sense of justice. Why not make such traits the centerpiece of recruitment practices at top level agency jobs rather than waste tons of red tape that are the delight of corporate lawyers?

  73. “we can´t even get hold of their names”

    but that’s implying a clandestine operation in full view of everybody … but for what purpose

    I am strictly against conspiracy theories whenever conspiracy-like things happened they happened kind of for every one to see just nobody connected the dots. To get people to agree when there is no strong leader involved or profit promises golden rewards is notoriously difficult, even impossible
    would Basel II have promised profit for any state coffer of the ones involved, any personal advancement like boss of this or that – there must be something, if there isn’t I start to believe in transsubstantiation

    So do you know of any major changes/policy shifts after or around or before June 26, 2004 this agreement might have prevented from becoming harmful (I mean not in the field of finance, maybe in the commodity market where a supplier might have had the power to challenge one or several of the G10) – I can’t remember anything 2004 was not my year

    good politics want to stay in power as long as possible and cash in on their insider knowledge after that period so I think corruption can be ruled out and no matter who the signatories were they surely must have acted on order

  74. I do not understand much of Gretchen Morgenson’s piece in the NYT but as the word regulate appears in it quite often I post the link

  75. I think it was Albert Einstein who said –

    “Any intelligent fool can make things bigger and more complex… It takes a touch of genius – and a lot of courage to move in the opposite direction.”

  76. Richard Hoogesteger here attributes “regulatory capture” to a weak civil service and how the American political system works. Here is what Hoegsteger said:

    “Simon-The problem your post addresses is really several different issues wrapped together. The first part of the problem is that we don’t have a proper civil service in the United States. One of the “reforms” of the the Reagan era was to triple the number of political appointees in government. The number of direct presidential appointees went from about 1000 to about 3000. These people often had hiring authority themselves so the effect on the federal bureacracy was enormous. This meant that, for example, the head of the Detroit office of the Department of Housing and Urban Development was a political appointee instead of a civil servant. He in turn would hire most of the professional staff including attorneys.

    This made it possible for politicians to interfere in regulatory agencies enforcement actions in ways that had not been done since the 1930’s. In Texas both Vice President Bush and Speaker Jim Wright would request the transfer of Bank examiners who asked too many questions about questionable practices at savings and loans. Needless to say this contributed to the size of the S&L crisis.

    “Regulatory Capture” is not something inevitable, it is the result of how the American political system works. A weak civil service cannot enforce laws impartially because of political pressure. Community bankers can legitimately fear that only politically weaker small banks would really be regulated by a CFPA.

    The second part of the problem relates to how politicians run for office. They beg for money, often from the very same big money center banks who have caused this crisis. Even politicians in midwestern states like Minnesota take money from the big money center banks. This causes community bankers to believe that any regulations put in place would probably be designed to protect the big money center banks from competition. I remind that President Roosevelts first attempt at regulation, the NRA was designed to protect large firms by reducing competition.

    Additionally small banks often have to deal with big banks. Sometimes not alienating people they do business with is also a factor.”

  77. Questions: Would it be feasible to (1) create legislation against political interference in the civil service? (2) rebuild the American civil service?

  78. Most enjoyable read, Bond Girl; hopefully you will appear with some regularity. I am in total agreement with your analysis, your solution less so, but at least it veers from the status quo, so thank you. I am sympathetic to Anne and Mr. Beria’s calls for a pound of flesh via the legal system, which seems to be missing in action in this whole fiasco. I’m also afraid that, as posited by Tony Foresta, the capture (e.g., bribery, collusion, market manipulation, ruthless deception, etc.) is or has become the essence of capitalism.

    My background was as an investigator in federal court. We often dealt with influential, monied individuals, albeit, following conviction prior to sentence. So, no, we were not looking to curry favor for our future enrichment. However, our fealty was to the court and our sense of responsibility to carry out our investigation impartially stemmed from that position. I believe Bayard’s idea that a regulatory agency composed of independent, motivated, brilliant investigators/regulators, in the model of those employed by the federal court system, but very well-paid and rewarded for uncovering fraud and abuses, has much merit. Obviously, the agency for which they toil would need to have serious regulation of the financial industry as its reason for being or it would be, as it is now, an exercise in futility.

  79. What is “legislation”? –

    Some words written on a piece of paper by some rich people who have derived their power from contributions from other rich people, and whose continued reign is dependent on contributions from those same rich people. Kinda like a bunch of King George III’s.

  80. In response to : Tippy Golden who says: politicians […] beg for money, often from the very same big money center banks who have caused this crisis.

    That’s human fallibility and cannot be altered. However, there are exceptions. Take Paul Moore (HBOS/UK), for example. That guy is just hard wired to do the right thing in the face of enormous peer pressure and would make an unbreakable regulatory boss.

    The question is: 1) can we identify the Paul Moores? 2) Can we change the rules to reward people like him?

  81. Bond Girl has in effect proposed a market solution to a legal problem to deal with (quoting mag on money): eg, bribery, collusion, market manipulation, ruthless deception, etc.

    This raises a good question: Can a remedy for corruption in the financial system be found through market innovation, or by strengthening existing government institutions?

  82. The rating agencies are supposed to be a market solutions. Has it worked?

    The point I was raising was : would it be ludicrous to shift our thinking away from incentives to change people or institutions to incentives for recruiting and rewarding those that do need (much) incentives to do the right thing for top regulatory jobs. A kind of trickle down principle, albeit in the public sector.

  83. Well I should have expressed myself clearer “I have not been able to get hold of their names”

    Of course and even though I have put up a brief blog, where I in jest treat the whole Basle affair as a conspiracy it is no conspiracy. I wish it was, then we would know how to attack it but mostly it results from that veil of peer loyalty and second or third degree interests that just lays itself heavily over the valley and allows a lot of stupidity to go on and that even silences any child that might happen to cry out an “the emperor is naked!” And of course this is not limited to Basel.

  84. Yes Tippy. The US and any country need a civil service because otherwise you get too many chiefs (inventing in Basel) and not enough Indians to do the basic jobs like stopping Madoffs. I am a foreigner in this country and I really do not like to get into anyone’s internal affairs but I would have to say that more than this crisis the way how the Katrina disaster was handled proves more the dire need of a tip top civil service. Reading how the US managed to put in place its wartime production engine in the last world war gives you a feeling that its governance capability has been since dramatically reduced.

  85. There is a gamut of free speech in American public life. From the spectacle of Medicare recipients rioting against government intervention in health care (hat tip to Krugman) to the public intellectual Michael Sandel, and everything in between.

    I am very persuaded by Sandel when he says: The most fateful change in the past three decades is — not a sudden increase in human greed — but a faith that began with Reagan and Thatcher that government is the problem and the markets are the solution. Without a proper debate markets and market values have expanded into spheres of traditional values.

    Mag on money, what do you mean when you say as a federal court investigator you had a “fealty” to the court?

  86. cityislander writes “The rating agencies are supposed to be a market solutions. Has it worked?”

    It never was a market solution. The problem was that the regulators confused all when they outsourced the risk-surveillance to a small oligopoly and called it market because the credit rating agencies were private.

    Here we have the million of eyes of the market being replaced by only 3 credit rating agencies. Do you think the libertarians would have remained silence if the credit raters had worked for the FDIC for example? Comes to show that libertarians aren’t what they used to be either.

  87. To mag on money and Per Kurowski who says “It never was a market solution. The problem was that the regulators confused all when they outsourced the risk-surveillance to a small oligopoly and called it market because the credit rating agencies were private.”

    The regulator is always going to have its hand in the market no matter what, so saying it wasn’t a market has never convinced me.

    If the demand for independent research had been greater than supply, that would have prompted new entrants. 1)It didn’t happen, because the banks were only content to sell junk bonds at higher ratings than they were worth. 2) And even if they were at the receiving end of the trade, having AAA rated bonds that is really worth AA only kept capital requirements lower.

    In view of 2) I’m really wary of the “keeping a skin in the game” argument as a solution to prevent future crises. Banks had a skin in the game. They just weren’t liable to clean up after the mess.

    The power of the law in the hands of an impartial regulators is the still my ideal model and mag on money’s answer hints at some solutions.

  88. Thanks Tippy, but let us not forget those who are crying.

    At this moment many bank clients who did not have that good ratings or where unrated are being shown the streets by the banks because the bank´s previously high rated clients are sucking up all the bank equity there is as they are getting downgraded. It is a disaster and so little is being discussed about it because how can you discuss something you can´t even understand? Therefore politicians find it more comfy to stick with the local issues such as bonuses and bank oligarchs and not trying to make sense of what the US agreed to do when signing the International Convergence of Capital Measurement and Capital Standards: a Revised Framework

    Amazing rarely have I seen a country so opposed to allowing itself to be influenced by foreign legislation as the US and here it signed up its whole financial system to a framework that basically goes against free markets.

  89. cityislander “because the banks were only content to sell junk bonds at higher ratings than they were worth”

    Business in general is based on selling something at a price higher than what it is worth so that is not the real problem. The problem resides that with the capital requirements for banks based on risk, the regulators increased the value of the differences in risk. They sort of leveraged the risk valuation. So it became more profitable to sell risk differences, whether these were perceived or real.

  90. To Kurowski on “Business in general is based on selling something at a price higher than what it is worth so that is not the real problem”.

    To me that is a non-competitive market. It may be pro-business, in the conservative discourse, but that is not what Adam Smith intended.

  91. All I can say is that if President Obama plays his cards right, Mr. ex-President Obama is going to be the wealthiest ex-Pres in history….



  92. cityislander “To me that is a non-competitive market”

    The competitiveness of the markets minimizes the margins but the driving force is still to sell for more than it is worth or to buy for less than it is worth. What the regulators did here was to order that anything capable of hustling up an AAA was worth an additional premium and anything that was seen as more risky had to pay the extra cost of the extra capital requirement. And this, of course, on top of what the market already charged for risk-differentials.

  93. About “The problem resides that with the capital requirements for banks based on risk, the regulators increased the value of the differences in risk.”

    Perhaps, but if Greenspan had thought that he wouldn’t have rebuked both (by his own admission) the best Fed governor he ever knew and Brooksley Born when they told him that predatory landing and CDS’s were a problem? He would have told them that the problem lies elsewhere : capital requirements. Just thinking aloud about counterfactuals, here…

    Finally, you would think that if the banks had been liable to clean up after the mess, real differences in risk would have mattered, not the perceived ones.
    Yet the precedents pointed to the opposite . “A few bad apples”, remember?

  94. cityislander “[Greenspan] would have told them that the problem lies elsewhere: capital requirements.”

    I am not so sure he must have known that he had bet everything on the infallibility of the credit rating agencies and could probably not even face the possibility of being so wrong. At the end he blamed “trusting the markets, bankers and shareholders too much” in order not to blame himself for distorting the markets by helping to impose the credit rating agencies upon them. (On the rest I will try to come back later.)

  95. About “Amazing rarely have I seen a country so opposed to allowing itself to be influenced by foreign legislation as the US and here it signed up its whole financial system to a framework that basically goes against free markets.”

    Yeah, amazing. What free markets? The socialized banking sector that the Neocons inadvertently delivered?

    “allowing itself to be influenced by foreign legislation” Just because they signed this doesn’t mean they have to bend over backwards towards the swiss in any other respect. At least they chose to sign it, that’s pretty good by current standards. The same can’t be said about the Chinese and the Saoudis who own our debt in the trillions, the last of which also feeds our oil gluttony.

  96. About “At the end he blamed “trusting the markets, bankers and shareholders too much” in order not to blame himself for distorting”

    With all due respect, I agree that sometimes you to have look beyond the surface. But here, I see a distortion of evidence that I don’t have the time to counter-argue: congratulations, you won!

  97. Tippy, While Webster’s defines fealty as “the duty and loyalty owed by a vassal or tenant to his feudal lord and an oath of such loyalty”…I was using the term to represent the relationship of an officer of the court to that court and as such, we were sworn in by the Chief Judge and had a code of ethics which prohibited even “the appearance of impropriety.” It is the galling lack of such rules in the whole financial regulatory sector, including Geithner’s cozy status with Wall Street when head of the NY Fed (and now) that is just incomprehensible.

  98. One solution might be hyperrewarding regulators for analysing, discovering, prosecuting and convicting finance abusers and criminals in the finance sector. Of course these rewards would be nowherenear the kind of obscene and ridiculous compensation we stupidly endure and tolerate from the finance oligarchs (who create NOTHING but bubble/burst economies and leave NOTHING valuable or measurable to the rest of humanity) – but yet – a kind of handsome paid bounty – and perhaps low seven digit bonuses, for analysing, discovering, prosecuting and winning convictions of the theives, swindlers, PONZI scheme charlatans, and criminals in the finance sector.

    Even the playing field by alloting some of the peoples dollars to reward regulators for the prosecution and conviction of PONZI scheme charlatans and outright , monopulists, collusionists, extortionists, bribers, frauds and other thieves and criminals in the finance sector.

    It’s either that, or insurgency!!! In a world where there are no laws, (like the one we live in now) – there are no laws for anyone predatorclass thieves, swindlers, and criminals!!!!

  99. mag-on-money, could you substantiate your criticism of Geithner in particular? FYI Roubini credits BIS and Geithner for foresight:

    Instead thinkers at the BIS and policy makers such as Tim Geithner, Jean Claude Trichet and Mervyn King had a more nuanced approach on how monetary and credit policy could be used to contain such bubbles. Tim Geithner devoted his first five speeches as President of the New York Fed to the issue of systemic risk in financial markets; he also warned about the unsustainability of the US twin deficits at the time when Bernanke was blaming it all on the global savings glut caused by China and other surplus countries.

  100. Print more money. Spend it. It is that simple… If you prefer, have the Fed extend a 100 year loan to Treasury at 0% interest. We’ve already been expanding base money as the world deleverages, _without_ seeing inflation. I’m simply suggesting that we make the deleveraging permanent, to put a limit on leverage as velocity picks up.

    I cannot imagine, however, that this idea will gain any traction whatsoever among the Powers-That-Be. Permanently increasing cap/asset ratios reduces the ability of private banks to print money for their own use; they would fight it desperately.

  101. Thank you StatsGuy for your succinct analysis. I think that regulators need to recognize that an unregulated financial community is exceptionally risky for both the economy as a whole and as it impacts the lives of citizens (this crisis alone has been exceptionally costly in terms of job loss, portfolio loss, inability to retire as planned, inability to send a child to college, etc.)

    Per – the housing market traditionally was less risky – until, for whatever reason, a decision was made within the industry to ignore the borrower’s ability to pay back the loan. Once that decision was made – and the “no-doc” loans became fashionable – and approving loans that made no sense became common – and then such loans became securitized – the housing market became an extremely risky investment. And I do not for a minute believe that no one knew about this – it was too widespread a phenomenon for it be a secret to the big banks.

  102. Thanks mag-on-money.

    One downside I see to the United States outsourcing the war in Iraq to private contractors is an erosion of the meaning of duty. One might argue that financial security is also an issue of national security.

  103. When we refer here to Basel we refer to the Basel Committee that is hosted by the Bank of International Settlement and that results from the Basel Accord signed I believe in 1988 by the G10 and that confusingly enough includes the following eleven countries. Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States… and so it is far more than the Swiss regulators.

    I have nothing against the US signing up international accords much the contrary but I had to comment of how little is known about the Basel regulations for banks and their implications.

  104. Yes it is indeed amazing to read that even with this kind of insight the credit rating agencies kept on giving out AAAs to securities collateralized with lousy mortgages… because they worked with whatever information was sent to them and they said they had no responsibility to check up on the quality of the mortgages. High quality risk sentries eh?

  105. Geithner is a tax cheat. He can’t be trusted with anything.

    Please tell us what he actually ACCOMPLISHED in his 4-5 years as head of the NY Fed.

  106. “Frederick William paid the consumer tax he himself had imposed, and no candles were left burning at court. He lived frugally and worked hard and tirelessly for the welfare of his people. He encouraged farming, reclaimed marshes, stored grain in good times and sold it in bad times.”

    Autocrat or not (and he certainly was), I suspect most of the common people in Western Europe in any period before about 1950 would have VASTLY preferred this guy to their own rulers.

  107. chas:

    Please tell us what he actually ACCOMPLISHED in his 4-5 years as head of the NY Fed.

    Did you read my posts? He stood at the opposite end of the spectrum of those who ignored some of the red flags such as deepening twin deficits.

    Why should Geithner bear a disproportionate blame, without good evidence, when there’s undeniable evidence of wrongdoing elsewhere?

    It’s just beyond me that you can find comfort in accusations that are simply so easy to refute.

  108. Per Kurowski:
    confusingly enough includes the following eleven countries. Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States… and so it is far more than the Swiss regulators.

    There’s only one draft and it applies equally to all countries, perhaps with minor changes to accommodate local law.

    A team of regulators consulted with each other and wrote a collaborative draft. They spoke in English to each other, went to the same schools and some had probably been classmates, workmates or Golfing buddies. Experience was gathered from a larger pool which is not such a bad thing in a global economy.

    How is that confusing to you?

  109. PS: I said Swiss as an expedient, I thought I didn’t have to explain it explicitly.

  110. You still haven’t told us what Geithner accomplished for the 4-5 years he was head of the NY Fed. Standing at the opposite end of a spectrum is not an accomplishment. I’m talking about results, not speeches.

  111. chas : you’re only proving that should I take the pain to try to digg deeper you would only get back to me with the same stubborn attitude. Why bother?

    Only $300,000?! That’s a steal.

  112. Yes isn’t it amazing how much words like honour, respectability, decency have gone out of fashion sound dull and uncool while the vocabulary for achievers is still very much in vogue.

    and here is a piece on Paulson’s action in last September – Even if he is the most honest and scrupulous man on earth which I have no reason to doubt this closeness with his old employer makes me feel uneasy
    – wouldn’t if I were under heavy stress people who are able to speak the same kind of shorthand/insider language I have used all my professional life carry more weight
    – insiderish language provides a strong bond, makes one feel appreciated and valued, kind of with family, feelings people without the jargon take a lot longer to provide.

  113. the emergence of practically private armies in warfare once again made me very uneasy when I first heard about it

    – but since I have read up on the subject of logistics in warfare over the centuries a bit I had to admit that it is probably inevitable for any number of reasons the least being that when corporations all operate under the mantra of concentration on core business outsourcing everything else any other organisation must follow suit up to a point due to the simple fact that it doesn’t have big provide-all partners in industry anymore, the whole structure becoming flatter more net-like, less top-down. Even a military as big as the US probably cannot operate without adjusting to the Zeitgeist. Of course instead of outsourcing whole chunks the military could introduce intermediaries scrutinizing the markets, building reasonable packages etc. etc. I doubt the outcome would be any better and one thing the mancount of the military would become huge and can you imagine the anti-american rants that would generate.

    In my view the US is an empire and watching empires and all other people or institutions who wield power of your life with deep mistrust is only reasonable but I doubt that there ever has been in history an empire which was so benevolent (yes I know Vietnam but look at what others did through the millenia) and mind you I know something about how the Americans behave, having lived a long and major part of my life under American occupation (yes it was called that way and rightfully so, Germany became a sovereign state only in 1955, 10 years after the war, and fortunately they kept great numbers of their troops in the country till the first Iraq war and the jobs were German civilians they provided were most desirable)

    Also the private contractors were already there also for those US-troops being on the ground in the Balkans. Also I get the impression that life in the barracks or tents probably has gotten a lot better since the “privates” take care of it and since I think the job of troops is hard enough no matter how I am now basically resigned that the contractors are there for good reasons and that while the system is still growing and getting implemented a lot of stupid things will happen and hopefully being sorted out one by one until it gets out of fashion and something else will start to emerge.

    Also, fortunately the soldier of today is not the dispensible pawn he used to be but a highly trained and therefore extremely expensive to “produce” professional

    In the interest of all those in the profession I hope they remain valuable and very costly to those sending them in harms’ way

  114. ozajh
    Western Europe in any period before about 1950 would have VASTLY preferred this guy to their own rulers.

    WW2 ended in 1945 all over the world – in Asia later in the year than in Europe

    Europe experienced a period called golden before 1914 reaching back kind of to 1871 – ever heard of “Belle Epoque” – a good read-up would be the autobiography of Stefan Zweig

    WW1 ended in 1918 even though things stayed very chaotic in Germany way into the 1920s my mother born in 1913 a laboratory assistant (10 years of school, apprenticeship of 3 years i.e. being a salaried employee at the age of 19/20) really lived a totally modern good life of a well employed single woman in pre-war Düsseldorf (by the Procter&Gamble competitor Henkel) including eating fast-food take-outs ;-)

    I wonder who it is shaping the impression of so many people that the world before our current time was all gloom and misery

    however, regardless of previous golden times whenever I feel the temptation of longing for a strong hand to finish the messy day to day of life in a democracy I remind myself that if you want to bring well-being to greater numbers of people autocrats are not a good bet

  115. I’d do one better: pass a law requiring financial circuses firms (howsoever defined) to operate as straight partnerships or limited partnerships, with each partner as a general partner as a condition of doing business. Add in far-reaching clawback provisions preventing sequestration of assets.

    In other words, every partner would face unlimited liability for firm debts. This would make the partners far less cavalier about gambling OPM, since they will be gambling their own.

    That would make some ears prick up. But it might end up as communism.

  116. “This would make the partners far less cavalier ”

    I read that AIGFP or was it another one of the main contributors to the “crisis” expected its employees to buy company stock for half of their yearly bonusses which means they by now they should be far from bankrupt but have lost a lot

    – therefore the argument that having a heavy financial involvement/interest in the well-functioning of the system or even the own employer would prevent anything is void

    – politicians in Germany still peddle the idea vigorously in the beginning campaign for the election but only because of the language barrier they have an easier time of it pulling the wool over our eyes

  117. Right on the dot. The most alike Basel regulators I have met are those regulators from faraway countries that do the most they can to show themselves off as alike the originals… and of course usually come from the same school of central banking.

  118. Yes autocrats are not a good bet. My homeland is under the thumbs of a petro-autocrat!

    Might it be that the elites are not what they used to be either? You see I cannot be overly impressed by the fact that so many seem to think it is a swell idea putting so much power in the hands of some few credit rating agencies… and believing one can really wrestle risk out of banking without introducing other and worse risks… and even believing in that we wanted to get rid of risk instead of trying to get hold of the right kind of risk-taking.

  119. “Might it be that the elites are not what they used to be either?”

    no use asking that question of someone who has just finished reading a three volume history of Byzantium.

    elites are the way they are
    – when benevolent paternalism is the fashion of the day they will scramble for furthering it when mindless gambling is the fashion of the day they will also go for it
    – Obama for my taste smacks too much of the benevolent community organizer attitude to start a fashion leading away from the gambling creates wealth cry of the day

    – it comes back to the question who will write the next “Jungle” or create anything else that all of a sudden makes the Zeitgeist pursue the next widely acceptable idea which in the beginning like many great ideas may be not bad at all then be pursued to excess but hopefully, always hopefully, next time be reigned it before it leads into catastrophe.

    elites are for better or for worse behaving just like the rest of us and they will only play a role in being the first ones identifying a new idea/direction worth to be followed – lets hope it will be one remaining beneficial longer than the last one and not some bored ladies in the salons of Munich getting turned on by a young Adolf playing with his riding crop (which was were he learned manners if nothing else)

  120. (1)Yes and (2) yes. Prior to the FDR administration, the US civil service was, as were the state and local administrations (and remain), a vehicle for political patronage and job security for elected politicians. FDR’s administration changed this situation completely.

    Your questions can be answered in the affirmative, but, under what conditions would a reconstruction be feasible? Do we need 25% unemployment, failures of a third of the nations banks, the loss of 70% of the value of financial assets (and lost savings) and another world war? Can we muster the will to do it?

  121. Silke: “Yes isn’t it amazing how much words like honour, respectability, decency have gone out of fashion sound dull and uncool while the vocabulary for achievers is still very much in vogue.”

    This is an interesting observation. I believe Bond Girl is a Nietzsche fan. She could say this is part of a reversal or inversion of values accomplished by the bankers.

  122. the Prussians of old, I think it was Frederic the Great died in 1786 shortly before the French revolution created the first corruption free civil service in the region by creating the Beamte a special kind of salaried employee only to be found in government offices who enjoyed guarantee of lifelong employment good old age pension etc. and probably very little incentives for competition

    If he however would be caught stealing the proverbial silver spoons or even insinuating that he was open for a bribe or swayed by a favour he would be evicted from his safe haven and severely prosecuted.

    so in a way a still very absolutist king created the perfect civil servant for the benefit of his state by giving a kind of paradise to said servant

    I guess the typical unflappable Prussian Beamte is what all those with government phobia have in mind. Because he wouldn’t take a bribe but wouldn’t deviate one millimeter from his book of rules or read it creatively.

  123. I believe Bond Girl is a Nietzsche fan.

    she said so once – I have given the book after she mentioned it a try (at German gutenberg) can’t get myself to read that kind of to my brain pompous language
    – funny that English books from the same time I find completely accessible and often real page turners
    and that even though I have never been taught the language properly just picked it up in bits and pieces starting from a very small background from school years
    Therefore I guess that it must be something in our natural character of the time which favoured pompous writing, because we wanted finally to become an empire also?

    After all I really enjoy the earlier writers especially Schiller (the one with the freedom of thought) but maybe that is because he wrote stuff hinting at strong socialist inclinations.

  124. Krugman makes the same point in “The Conscience of a Liberal”. He views the origin of the paradigm shift observed by Statsguy as the writings of William F. Buckley, Jr. in the late 1940s and early 1950s. It’s not about whether we are more or less greedy than our ancestors. It’s about how we view our greed, among other factors, of course.

  125. Why do you stubbornly refuse to back up your earlier comments about Geithner’s qualifications?

    “Only $300,000?! That’s a steal.”

    You still haven’t told us what we got for our money

    Why, with all that authority & his supposed qualifications, did Geithner fail so miserably at his primary responsibility of preventing the crash of the financial system?

  126. That was an outstanding post by Bond Girl. I really like the idea of giving regulators the appropriate incentives.

    By inviting knowledgeable commenters such as Bond Girl or StatsGuy to post full articles, J. Kwak and S. Johnson are making this blog legendary.

  127. You are right BlackSwan though some of us would perhaps phrase it more as us having a need for some better incentives to get ourselves some good regulators. Apparently a mega-crisis does not suffice. I have not heard about the first regulator who has been fired because he did not regulate well.

  128. The first comment by stats guy summed up the key point. If the regulators (Greenspan the Ayn Rand Wanna be and the PResidedent) don’t believe in regulations and do everything possible to weaken regulations, no system, no incentive system is going to work Plain and simple.

    “At root, our defenses against the corruption of financial regulation were ripped down by two decades of Friedmanomic dominance. The belief that government is essentially bad, no matter how well it is implemented, and the markets cannot be wrong. That, furthermore, free markets are right even when they are visibily distorted by gross market imperfections that any layman recognizes.

    That greed _itself_ is good.”

  129. Except for the last paragraphs, way too many abstract statements — and too few examples. Hard to read! At least one wrong statement – “We think about regulation only in terms of how to engineer the incentives of the regulated”. What about “Truth in Lending” act, for example?

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  131. Seems like a federal judge agrees with me – from SEC, BofA proxy statement proposed settlement.

    From FT –

    “A judge refused to accept a proposed settlement between regulators and Bank of America over allegations of misleading investors in a proxy statement and pushed the Securities and Exchange Commission at a hearing late on Monday night to identify who at BofA was responsible for the alleged mis-statements.”

  132. that sounds like a great idea. kind of like the FASB, they want to be considered honest but independent judges of financial information. but people would cry socialism because the fees would be “regulated” by the gov’t.

  133. I was against going into Iraq because I think things hadn’t changed enough since the British struggled there to make a difference (applies to Afghanistan also*)), but look at Iraq on a globus, not on a map. If it had worked it would have been great/gorgeous/phantastic/real smart
    – and now when it started to have at least a chance to work out after all? – operation interrupted – poor Odierno

    *) there is at a great piece by Churchill who was in the exact same area (Malakand) they are fighting today – makes even an agnoist pray continuously that some supreme power may protect your and any other soldiers who may have to operate there
    and by the way Churchill even in 1897 knew how to tell a story that can compete with all the thrillers out there

  134. The raison d’etre for the financial industry is to move money from one person’s pocket into another’s. They do not create goods or money, and they only create “wealth” for themselves or anyone else by taking it away from greater fools somewhere.

    “Innovation” in finance means new angles on the game of parting a sucker and his/her money. Aside from hallucinagenic claims by the followers of Professor Friedman, no one disputes that financiers don’t “produce” anything tangible except income for themselves and their associates. Neither do lawyers, a therapists, or musicians.

    However, we don’t need to eliminate or even regulate financiers any more than we need to do so to lawyers, therapists, or musicians. Beneficiaries of these services (the one’s into whose pockets the money moves, in the case of finance) don’t want them restricted, and losers in the money-moving game need to read Bond Girl’s article and get it that we will have fair, competent, and thorough regulation of finance on the same day we disband our military and the electoral college and return the western U.S. to Mexico.

    What we actually need is simply honest and transparent reporting at all levels in the finance-government industry – say, at the level that’s required on a cereal box. Then let caveat emptor work its way, and at least the lessor fools who still believe in capitalism will have a fighting chance. Now, what are the odds of such a reform?

  135. BG: “I would argue that the fundamental flaw in financial regulation is that it is based on the assumption that regulators are not self-interested individuals like the rest of us.”

    I think this is actually the assumption that has guided deregulation over the past three decades. Regulators have been stripped of their capacities precisely because we believe they are incapable of acting selflessly ( Although Bond Girl is correct that issues of capture are rampant, a prior question is why have the macro consequences of capture become more rampant in the last few decades (S&L, LTCM, current crisis)? Her story doesn’t account for the fact that for fifty years we were relatively crisis free — our regulators have not become more self-interested and the financial services industry has always been much better organized and resourced than the concerned public, so what has changed? I think it is that regulatory institutions have been enfeebled.

    Bond Girl not only fails to account for any temporal variation in the degree or consequences of capture, but also fails to look across industries. I think that Moss/Oey ( and Croley ( provides several examples of regulators that have served the social interest despite being faced with organized, countervailing industrial interests. She is too quick to generalize from a particular historical moment that may not actually be exemplary of regulation.

    BG “Adding another layer of guards to guard the existing guards ultimately results in an infinite regress. I do not think it is cynical to suggest that, absent an actual paradigm shift with respect to accountability in the financial industry, we are just going to have more of the rent-seeking that has gone on to date and the economic calamities that ensue. For my part, I would propose opening up financial regulation to a small group of social entrepreneurs. Let people establish for-profit companies that can compete for government contracts to stress test the holdings of financial institutions independently and audit their records.”

    Bond Girl’s generalization leads her to an ontological understanding of regulators as selfish and corruptible. This then forecloses the possibility of oversight in the public interest. What’s needed then is oversight in the private interest — we will simply create a regulatory industry that competes on the basis of diligence for government contracts.

    Private credit rating agencies have not served the public interest, why should we expect that this new body of regulators would do any better? Also, how does this even solve the problem of capture? Now all an industry has to do is co-opt the few people who are awarding the contracts to the new private monitors — this can happen cognitively (i.e., deep capture — award the contracts to monitors that understand that what’s good for business is what’s good for America) or through more traditional forms of capture. Bond Girl is rightly upset about the revolving doors between the financial sector and financial regulators, but who does she think will staff these new private bodies?

    BG: “The administration’s proposal appears to portray the financial crisis as nothing more than an accident of reasoning. Because financial regulation in our country evolved in a fragmented manner, regulators’ perceptions of risk were determined by their respective niches when a holistic understanding of risk was required to predict a market failure of this magnitude.”

    Systemic risk is a clear example of an externality that needs to be regulated, so that the costs are born by those originating the risks.

    Also, the push to regulate is larger than simply creating a new macro prudential regulator — think about CFPA or derivatives. This re-regulation doesn’t just take a holistic view, it takes a new view of the financial sector that recognizes the incentives these firms have to engage in activities that are contrary to the common good.

  136. Stats Guy,

    In my other posts, I pointed to one solution : Rather than incentivizing the wrong people to do the right thing, how about making integrity the centerpiece of top level appointments?

    Another solution is : complex regulations are the delight of corporate lawyers and make it more difficult to discern whether an agency is enforcing it or not.

    In the Glass-Steagall paradigm, the web of interconnections linking household bank deposits to Lehman brothers simply would not have existed.

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