Two Good Thoughts About Financial Reform

From Economics of Contempt (hat tip Brad DeLong):

“The single best thing we could do for financial reform: Triple the budgets of all financial regulatory agencies. Immediately. Regulators are woefully understaffed; this is fact.”

I’m not sure about “single best,” but otherwise dead on. The agencies that are self-funding out of their businesses (banking for the Federal Reserve, insurance for the FDIC) have been less bad than the ones that are not (OCC, OTS).

“Some people will claim that it’s impossible to distinguish between market-making trades and propietary trades, but that argument is completely baseless. The banks themselves already distinguish between their market-making trades and their proprietary trades, as there’s a whole different set of rules for proprietary versus market-making trades. So don’t be fooled by that argument.”

The context here is that, technically speaking, the ordinary business of executing trades at the request of clients does involve some risk for the dealer. EoC talks specifically about market-making, where a dealer has an obligation to post a bid and an ask for a certain security. Since it can’t balance it the buy and sell orders instantaneously, it generally carries “inventory,” meaning that it’s long that security. But his point is that banks already divide their business along these lines, so saying they can’t is hogwash. Obama’s proposal might give banks an incentive to try to sneak one kind of trading under cover of the other, but that’s something that could be policed; it’s not like it’s theoretically impossible to distinguish the two.

By James Kwak

14 thoughts on “Two Good Thoughts About Financial Reform

  1. One of your better posts James (more useful than getting the pompoms out for Krugman, really). Definitely one of your better finance related posts. Although I have to say I’m surprised at EoC’s stance on this. In the past he has argued AGAINST registered exchanges for derivatives markets, so I always considered EoC a pro-speculation, pro-dealer type of guy, and I avoided visiting his blog on a stand of principals (I often don’t click links I feel make immoral arguments even if they make intelligent immoral arguments).

    Maybe I had EoC wrongly pegged??? My perception of him is wrong??? Either I was very wrong about EoC or there is a rat here somewhere…. this one I need to reassess/consider again.

    But I DEFINITELY agree with EoC’s words that James quoted in the above post. This is a terrific post James, short but insightful.

  2. I disagree with Bronte’s/John Hempton’s opinion here (in the link I give below). Let me make it clear I think his stance is wrong. But I found this link on Thoma’s site this morning and it could be educational for anyone having some problems grasping the concepts here. I think I know more than most on this, but really myself I have only scratched the surface on this topic. But this link is useful trying to grasp difference between proprietary trading and market-making trading.

  3. James, I’d like your thoughts on this idea:

    Dr. Krugman, I’d like to hear your thoughts on this idea to radically and quickly decrease unemployment:

    To immediately reduce joblessness, I propose Congress open up a “temporary early retirement window” within Social Security and Medicare, to wit: “Any presently employed private-sector individual, age 60 to 65, who elects to retire between (for example) Jan. 1 and March 31, 2010, will receive full Social Security and Medicare benefits as if they were 65 years old, subject to the same outside compensation limitations as are in place within these current programs.”

    The added costs to Medicare and Social Security would be paid for through the government’s general fund, and not born from the programs themselves, which would further weaken them.

    According to the Bureau of Labor Statistics, there are currently 27 million workers above the age of 55 (no data immediately available on those 60+). Let’s assume conservatively that only a third are age 60-65, and only one third of them would be in a financial position to retire under these circumstances. That’s still 3 million workers.

    Then let’s conservatively assume that companies only replace half of the workers who leave: that’s still 1.5 million newly opened jobs that would be filled from the ranks of the unemployed. That translates to a 10 percent reduction in the current jobless rate.

    On the cost side, the cost of adding these benefits are largely fixed, and easily calculated: they are the cost of a maximum of five years of Social Security and Medicare benefits, offset by the percentage of those who would have taken Social Security at 62. Medicare benefits would also come cheaper than normal because, according to an actuary friend of mine, this population trends at a 30 percent discount to the remainder of Medicare recipients.

    By opening this temporary early retirement window, Congress would also be letting some of the air out of the wage inflationary bubble that will occur when the Baby Boomers retire en masse and companies compete to fill the resulting vacancies from a smaller workforce. Companies would also be able to save money because they would be replacing largely higher-priced talent with lower-end beginning employees on their payroll, while employees would

    benefit from the vacancies up the promotional ladder that would result from the retirements.

    By limiting the “window” to three months, Congress would provide an immediate shot in the economic arm for very little relative cost, do so in an election year, and finally provide some job-targeted stimulus that would start to restore confidence in the economy.

  4. It is easy to distinguish between proprietary and market-making trade. I know the administration wants micro-regulations that will somehow define the difference for all time. But as soon as they are written, a route around them will be found.

    The easiest test is that commercial banks should not be allowed to keep positions open over-night or, better yet, for more than an hour or two. If the customer order is so hard to execute that it cannot be done in this time frame, send the customer to an investment bank or broker-dealer.

    Commercial banking is simple and depositors are guaranteed they will get their money back (up to a reasonable point). Leave the risky or difficult stuff for investment banks or broker-dealers that operate without guarantees. Better yet, require the latter to operate with employee-owned equity and all the debt they can raise. Then see how much risk they take on.

  5. Upon further research into EoC’s blog, and review of his past comments I would treat EoC as a very evil and vicious wolf in sheep’s clothing. He’s right on this specific issue, but it seems, in my opinion, only for matters of his own convenience.

  6. I think the Volcker Rule is a very positive step in the right direction. But if there is no registered exchange for derivatives, and no proper enforcement of capital requirements for derivatives, I think the “firewall” between investment banking and commercial banking will be about as effective as the current “firewall” between AIG and Treasury funds is now. Meaning “firewall” sounds like a very empty word to me.

    I think we need REGISTERED EXCHANGES FOR DERIVATIVES and we need investment banks and commercial banks to be ENTIRELY separate entities.

  7. “The single best thing we could do for financial reform: Triple the budgets of all financial regulatory agencies. Immediately. Regulators are woefully understaffed; this is fact.”

    Forget it! If they have been able to do so much damage with the current budget… can you imagine what they could do with triple of that? No they have to earn their right to larger responsibilities and larger budgets. You are here thinking about allocating more resources to those who reduced the capital requirements for banks to only 1.6 percent just because they lent to something stamped AAA, or to those who were not able to catch Madoff…you’ve got to be kidding! (I am)

  8. Re: The distinction between MM trades and prop trades –

    This is why we need to actually re-instate Glass-Steagall rather than trying to build walls within existing financial conglomerates to restrict where depositor-sourced funds may be used.

    Under Glass-Steagall, commercial banks accept deposits and make loans (and hold government securities) but that’s it. There’s no “trading”, for clients or otherwise.

    Granted, this will only work if the shadow banking system is brought out of the shadows, and any firm that creates anything that looks like a bank deposit gets regulated as a bank.

  9. EoC’s suggestion — regardless of motive — is spot on. Right now, there are at least 4 years of records sitting at the SEC filed since 2004, that are largely untapped as an audit trail and history of the accumulation of risk, and summary of exposures. I refer, of course, to the SEC’s Consolidated Supervision of Broker-Dealer Holding Companies:

    Least we forget, this was ushered in by none other than Hank Paulson in 2000 as CEO at Goldman. (You’ve got to read to the end to catch it.)

    He got the bankers formerly known as investment bankers everything they asked for, and then some.

    As things now stand, there isn’t a soul at the SEC that can even open the files, let alone decipher what’s been reported. And, even if the system’s no longer in use, these records remain government property, and accessible. One could plausibly argue that getting the SEC to reconstruct the evolution of the former investment banks’ risk profiles is as likely as 1000 monkeys with typewriters knocking out Hamlet (even if they had 1 million years to try). But they at least have to pretend to make the effort.

    Be that as it may, once the FCIC attempts to build the AIG audit trail (and a lot of other audit trails once that’s opened), they’re going to have to turn the data over to folks that understand what they’re seeing. Right now, the smoking gun, the rounds, the market feeds during, the sequenced order entries, and the daily PnLs and marks of all the broker-dealers that were massively short AIG in every way possible could be given to the FCIC and its staff, turned over to the SEC or the FED, and all you’d get is wide-eyed, slack-jawed incomprehension.

    Doing a bottom’s up forensic rebuilding to the risk accumulations (outright shorts in the 100s of billions of dollars notional) that resulted in the AIG conduit paying out $62 billion (!) to cp’s is going to take a lot of work. FIguring out who loaded up all the other dealers with the risk that required them to short the bejesus out of AIG is another trail that has to be pursued. And it’ll require the same expertise. And it likely will get the same slack-jawed incomprehension.

    To be clear, one does not count coup on $10 or $20 of PnL from a single counterparty intermediating “customer risk,” or market-making on customers’ behalf. Payouts like that are a generational milestone, something that probably hasn’t happened since ole JP Morgan himself shook down the US Treasury (but that’s another story). These sorts of payouts require the boat be loaded up to the point of dangerously listing — then forcing the rest of the broker-dealer community into the same risk profile, so that the sums owed can only be paid out by the federal government.

    There’s another, related, line of inquiry that will require a forensic re-construction: Determining just when the large cp’s figured out AIG could not possibly pay out, and that the US Government would have to be forced to seize AIG. This will be particularly significant. Especially tracking the mobilization of the network that made this occur. The same forensic evidence likely will show how the two investment banks left standing — MS and GS — were allowed to so quickly convert to commercial banks. Here, Messrs. Paulson, Friedman and Geithner are the dramatis personae. Their phone logs, emails, cell-phone records, meeting logs will be key here. (James, does the FCIC have to issue a do-not-destroy order in this instance to ensure these records are retained?)

    All of this requires people who know how to read these records and follow the trades and events. These people obviously do not work for the SEC and never have. On that score, the evidence is overwhelming. A good starting point would be some very public announcements re staffing up for just this purpose. And a permanent buildout of the SEC’s, CFTC’s, FHA’s and the Fed’s forensic capability. Followed by the hiring of such people. (Probably a lot of them looking for work in NYC right now.) The phone calls, emails, txt messages, etc., and hard-copy paper trails most likely are routine FBI stuff, and the necessary expertise is available there.

  10. If tripling the budget would be a good thing as long as the new hires are not recycled former wall street employees. They are plenty heartland people available.

  11. “The agencies that are self-funding out of their businesses (banking for the Federal Reserve, insurance for the FDIC) have been less bad than the ones that are not (OCC, OTS).”
    Correction: the OCC funds itself from fees levied on banks it supervises.

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