Financial Reform: Will We Even Have A Debate?

By Simon Johnson

The New York Times reports that financial reform is the next top priority for Democrats.  Barney Frank, fresh from meeting with the president, sends a promising signal,

“There are going to be death panels enacted by the Congress this year — but they’re death panels for large financial institutions that can’t make it,” he said. “We’re going to put them to death and we’re not going to do very much for their heirs. We will do the minimum that’s needed to keep this from spiraling into a broader problem.”

But there is another, much less positive interpretation regarding what is now developing in the Senate.  The indications are that some version of the Dodd bill will be presented to Democrats and Republicans alike as a fait accompli – this is what we are going to do, so are you with us or against us in the final recorded vote?  And, whatever you do – they say to the Democrats – don’t rock the boat with any strengthening amendments.

Chris Dodd, master of the parliamentary maneuver, and the White House seem to have in mind curtailing debate and moving directly to decision.  Republicans, such as Judd Gregg and Bob Corker, may be getting on board with exactly this.

Prominent Democratic Senators have indicated they would like something different.  But it’s not clear whether and how Senators Cantwell, Merkley, Levin, Brown, Feingold, Kaufman, and perhaps others will stop the Dodd juggernaut (or is it a handcart?)

This matters, because there is more than a small problem with the Dodd-White House strategy: the bill makes no sense.

Of course, officials are lining up to solemnly confirm that “too big to fail” will be history once the Dodd bill passes.

But this is simply incorrect.  Focus on this: How can any approach based on a US resolution authority end the issues around large complex cross-border financial institutions?  It cannot.

The resolution authority, you recall, is the ability of the government to apply a form of FDIC-type intervention (or modified bankruptcy procedure) to all financial institutions, rather than just banks with federally-insured deposits as is the case today.  The notion is fine for purely US entities, but there is no cross-border agreement on resolution process and procedure – and no prospect of the same in sight. 

This is not a left-wing view or a right-wing view, although there are people from both ends of the political spectrum who agree on this point (look at the endorsements for 13 Bankers).  This is simply the technocratic assessment – ask your favorite lawyer, financial markets expert, finance professor, economist, or anyone else who has worked on these issues and does not have skin in this particular legislative game.

Why exactly do you think big banks, such as JP Morgan Chase and Goldman Sachs, have been so outspoken in support of a “resolution authority”?  They know it would allow them to continue not just at their current size – but actually to get bigger.  Nothing could be better for them than this kind of regulatory smokescreen.  This is exactly the kind of game that they have played well over the past 20 years – in fact, it’s from the same playbook that brought them great power and us great danger in the run-up to 2008.

When a major bank fails, in the years after the Dodd bill passes, we will face the exact same potential chaos as after the collapse of Lehman.  And we know what our policy elite will do in such a situation – because Messrs. Paulson, Geithner, Bernanke, and Summers swear up and down there was no alternative, and people like them will always be in power.  If you must choose between collapse and rescue, US policymakers will choose rescue every time – and probably they feel compelled again to concede most generous terms “to limit the ultimate cost to the taxpayer” (or words to that effect).

The banks know all this and will act accordingly.  You do the math.

Once you understand that the resolution authority is an illusion, you begin to understand that the Dodd legislation would achieve nothing on the systemic risk and too big to fail front.

On reflection, perhaps this is exactly why the sponsors of this bill are afraid to have any kind of open and serious debate.  The emperor simply has no clothes.

29 thoughts on “Financial Reform: Will We Even Have A Debate?

  1. So here’s a moron test if there ever was one.

    They’ll proffer a corporatist bill which not only won’t reform anything but will probably contain new assaults.

    “Progressives” may whine a bit but will all cave in without getting anything in return.

    The health racketeering travesty was only the most obscene manifestation of that longstanding pattern.

    So you can bet that’s what’s going to happen here, and in every case for as long as this system lasts.

    Anyone who’s still willing to believe in doing the same thing over and over again, believing of the latest iteration that “things will be different this time”, like so many wretches did with the health racket sellout, really does fit the definition of insanity.

  2. They’re not going to pass the derivatives regulations, or properly separate investment banks from retail banks, or get the regulators functioning outside of the Federal Reserve, or give proper funding or resources to the SEC and IT’S GONNA BE ANOTHER GIGANTIC MESS, MAYBE BIGGER THAN 2008–2009. It’s not IF, but only WHEN it will happen.

  3. We’ll be lucky to even get a resolution authority out of this.

    See the following WSJ editorial on why a resolution authority is unnecessary, that existing bankruptcy code is more than adequate, that Lehman is a shining example of how Chapter 11 can work for financial firms, and that a resolution authority would hurt US financial services competitiveness. I’m not making this up.

    We’re in for a battle here. The Dodd bill is roughly equivalent to the House health care bill – at the end of the day, what passes will be even more watered down. It’s a disgrace.

    One last point – every single time any politician claims this bill or any other bill will end “too big to fail”, the people listening need to immediately ask that politician to show them the provision that explicitly and immediately breaks up Citi, BAC, JPM, WFC, GS, and MS. No one on the planet denies those six firms are TBTF, and it’s absurd to claim to be ending TBTF without breaking up those firms. There’s probably about a dozen others that need to be broken up, but I’d be happy just to start with those six.

  4. Write your GOP Senator and tell him to GET BACK TO WORK.

    Stop shutting down senate business at 2 PM EST, after only TWO HOURS OF WORK.

    Yesterday, every committee was interrupted because of GOP petulance and revenge for the success of the Health Care Bill.

    Tell them to GET BACK TO WORK

    And in November, VOTE OUT THE GOP.

  5. If you attempt to break them up immediately you would get the worst depression in history, and you would create the most dysfunctional financial system outside of Africa.

  6. The R’s made the D’s in the Senate stay over, pass midnight, last evening (adding amendments to the healthcare bill – demonstrating once gain, how cynical and obstructionist it can all be….)

    The Administration will make the same impassioned plea (and again, in the 11th hour if the Administration and President Obama in particular, haven’t learned from the debates of last summer). Senator Dodd’s bill will end up with the same lack of meaningful reforms but as was with the healthcare bill, ending up with another political victory going into the Fall elections.

  7. So when do we do it? Next year? 3 years from now? 5? 10?

    The memory of the financial crisis is already fading.

    And why would breaking them up cause a depression? The component parts of these firms wouldn’t suddenly disappear.

  8. This is one of the most important arguments of the decade. We need to repeat it over and over, hammer it into the talking heads and politicos. We need to make the phrase “resolution authority” anathema to the public, while demonstrating convincingly the dangers of TBTF. That’s the only way to end up with smaller financial institutions.

    By the way, I still insist that the cap on liabilities as % of GDP should be extended to ALL private companies, not just “financial” companies. Otherwise, more and more of the financial world will slip into shadow banking territory.

  9. Mr. Johnson wrote:

    “Once you understand that the resolution authority is an illusion, you begin to understand that the Dodd legislation would achieve nothing on the systemic risk and too big to fail front.”

    Misdirection in magic

    “The study of close-up magic is a good introduction to misdirection. Misdirection takes advantage of the limits of the human mind in order to give the wrong picture and memory. The mind can concentrate on only one thing at a time. The magician uses this to manipulate the “victim’s” idea of how the world is supposed to be.”

  10. Would it be possible for the President to insert changes to how the bill will be implemented by using the signing statement tactic? That’s what George Bush used to do quite frequently

  11. Breaking up the banks would cast a chill over American finance. A big chill.

    A systemically important entity would be euthanized should it ever be become a systemic threat. It would be the law. If they are never again a systemic threat, they remain big and systemically important for a very long time.

  12. U.S. Bank Plans Don’t Tackle Cause of Crisis, RBC’s Nixon Says

    March 25, 2010, 7:22 AM EDT

    March 25 (Bloomberg) — The U.S. government’s proposed rules to rein in banks by limiting proprietary trading and investments in hedge funds don’t address the cause of the global financial crisis, Royal Bank of Canada Chief Executive Officer Gordon Nixon said.

    “It doesn’t do a lot in terms of reducing systemic risks,” Nixon said in an interview yesterday at Bloomberg’s New York headquarters. “Most of the institutions that actually went under weren’t even in the proprietary trading or hedge fund business.

    The Volcker would require federal banking agencies to issue rules banning proprietary trading as well as investment in and sponsorship of hedge funds and private equity funds at banks, bank holding companies or their subsidiaries. Such rules could be circumvented, Nixon, 53, said.

    “The business will move; it will either move into unregulated entities, or move geographically into other markets,” Nixon said.”

  13. I saw Barney Frank and Chris Dodd interviewed on CNBC yesterday morning. I kid you not, Frank said that we’ve already fixed all the problems that led to the meltdown. Furthermore, he said regarding too-big-to-fail, that the only liabilities the U.S. will cover in the future will be the really big ones that threaten to bring the whole system down.

    Did I just wake up and find myself in an alternate universe? What fixes have been implemented of the things that caused the meltdown? Also, in saying that we’d pay of the liabilities that threaten systemic chaos, isn’t he describing the very core of the issue that we need to fix so that we prevent such things in the first place? Why isn’t anyone listening to Mr. Volcker?

    This is abosolute madness. Nothing has been done yet to reform the financial system, and it appears that nothing will be.

  14. I’m with Rue – JCH you have not explained why there would be a depression if we carved up those six banks. I dont think any of the posters on this blog are foolish enough to accept your claim at face value, so please, explain the mechanics of the depression. The bankers will be so “chilled” they wont come to work for their new smaller firm? More likely that they will realize the marketplace just got some healthy competition and they will work twice as hard.

  15. Again, no doubt in my mind that the ‘crisis’ was an extortion tool to allow these TBTF to get even bigger. This of course after swallowing up all the competition in the 90’s.
    Wells now owns Wachovia-
    BOA-Merill and Country Wide(less ‘toxicity’)
    J.P.Morgan-Bear Stearns, Washington Mutual
    CITI-started the TBIF frenzy, powerful interests(Saudis) and men(Rubin)associated-given THREE huge bailouts.
    Goldman-bank charter, AIG bs, own our Government.

    So essentially we now have a Big Three, which will go down in the history books,(unless said books are burned):Insurance/Pharma, Military Contracting and Banks.

    Of course, this is not news to anyone who reads this blog, but has to be the response to the fear tactics given by the likes of JCH.

  16. Can we ever really get rid of TBTF? Even if we restrict banks in size to 3% of GDP, it is still possible that a scenario arises like in ’08. Say a situation like AIG arises in which they right CDS with reckless abandon. Then if they go down the contagion could spread to three or four other institutions of similar size turning into a TBTF situation.

    I guess transparency and regulation of all activities (especially off balance sheet) would only make that solution doable. The banking industry is a quasi-competitive industry anyway since they have endless money supply from the Fed.

  17. I just wrote to my senator, Cantwell, asking her to get tough on this, and pointing out (she *must* know this already) the political upside for her and other senators who do so.

  18. J.Blackwell is right: the problem is not (just) banks being too big. The financial sector is too big.

    If you want less of something, tax it.

  19. Breaking up the big banks would cause a Depression because it would be hard for them to figure out which of the five smaller banks to stick with all of the toxic loans.

  20. This is the best piece I have seen by Simon Johnson in the field of political–repeat, political–economy. Instead of spinning out fine rescue plans a la Elizebeth Warren and the rest of the Making Markets Work brain trust, Johnson soberly weighs the balance of class forces at work (a.k.a. the “agency problem”) and concludes that whatever “reform” served up by Sen. Dodd will be tailored to the needs of big capital.

    Now all that Johnson needs to do to graduate to big-time political economy is to subject the Obama Administration’s offerings for financial reform to the same class analysis. Unflinchingly applied, the result would turn out no better than the Dodd charade. (Openness and transparency have not been hallmarks of the Obama approach either, notwithstanding its celebrity endorsement by Paul Volcker; big finance is also the predominant influence among Obama’s top economic advisers.)

    Big capital needs free reign for oligopolistic bigness. Big capital needs Uncle Sham’s bailout when the moral hazard bill comes due. In a word, politics is the vehicle of economics, not academic theory. –These are a few of the facts of political economy absent from mainstream economics.

  21. The new reforms (not) will be comparable to both the tax law and the new health insurance reform law (not reform, but complex game rules) in that they will work in murky, complex ways to continue the rape of the American citizen. Until we eliminate campaign contributions and excessive terms in office, we will continue to get a professional Congress which is dedicated to supporting the plutocracy by enacting fatally flawed legislation. Simple as that. Sorry, but whenever someone opens his mouth from and elected office position, he is lying by telling toxic half or quarter truths. But we continue to listen. The media continues to report will little fact checking. And Washington keeps gaming us for their own benefit and the benefit of their rich and powerful friends. As they say in the cell phone business, its all about connectivity. About 320 million don’t have it, and about .001% of that number do, and they take our money and screw us. Simple!!

  22. Having spoken out against the “too big” when Simon Johnson was still in diapers (ok almost) and most certainly before it was fashionable, I totally agree that current reform presented before us will do nothing to diminish the too big challenge, quite the contrary.

    But having said that, let me remind you that whether it’s a monstrously big oil tanker or thousand of small sail boats, the death count could be exactly the same, if they go down in the same storm. And so, before solving the systemic risk of being too big, we need to solve the regulatory risks of having the banks all doing the same thing, like for instance following the low capital requirements resulting from following the credit rating agencies according to some totally arbitrary rules set by some very few regulators.

    The too big to fail, the too few credit rating agencies to follow, or the too few regulators to regulate, are just other dimensions of the problem with having too few of anything.

    And so what is most frightening is that this fundamental problem of true systemic risks is not even debated among those who should do nothing else but debate it.

    Now back to the too big ones… the worst problem with them is that they are so big they can negotiate the special treatments they should not receive… so really it is not the too big to fail aspect which is most worrisome but the too big and too few.

  23. Nothing changes. Dodd’s dud and the Volker ruse are merely sop for all of us. Nothing changes. No regulator or politician will ever pull the plug on a TBTF institution or introduce it to a resolution authority. They didn’t when it was most needed and they won’t in the future because they cannot drag themselves away from the teat.

    But we will find U.S. finance more isolated in the future because the EU is likely to do what we don’t. The U.S. will be left to bail out the rural school systems that bought into CDS’s and CMO’s. Retirees will soon find their benefits eaten up by investment bankers who are too eager to bail out the underfunded employers, public and private. Growing businesses will find themselves starved of capital because bankers find zero-sum products much more profitable than serious underwritings and the system will continue to spin out unfathomable products that make bankers rich and everyone else more prone to ruin. But don’t worry. Some of the excess will continue to be skimmed off for the politicos and a little more will be spent on corporate ads for politicos. And we’ll get more tv channels with more reruns and tea-partiers will bay at the moon and Dodd will retire with fat consulting contracts with the banks.

    Happy trails to you….

  24. thanks for the concise explanation. much appreciated. and good plug for your book. you’re a Publicist’s dream.

  25. It is becoming (almost impossible) to get any sanity into this debate, certainly at political level where it really counts. we have had in no particular order.
    stress testing – big fudge that one
    size cap proposals
    financial transaction levies
    leverage caps
    break em up
    tax them to death
    social utlity arguments
    Result no one does anything because they are fundamentally afraid of creating an economic disadvantage that threatens the narrow national interest. Same in the US, UK, Euroland or should that be Euro-Disneyland now. The G20 is a gabble shop and no firm and concerted action plan exists in any major legislature. Inteenational agreement – forget it. If you want to change this you have to impose a new corporate structure on the banks- that stops them in their tracks makes responsibility for careless underwriting a direct hit to those resposnible, not the taxpayer and stop tinkering with these solutions. This bill looks utterly useless

  26. JR Max Wheel wrote:

    “It is becoming (almost impossible) to get any sanity into this debate…”

    March 26, 2010, 3:19 PM

    Greeks, Romans, and Financial Reform – Paul Krugman – NY Times – excerpt

    “I’m all for passing reform. But I’m not that optimistic that it will work, even if it passes.”

  27. Have you noticed the delay between when you post a comment on Paul Krugman’s blog and when it appears sort of some day later when no one is following it any more.

    That is probably because you have to be extra-careful with Nobel Prize winners.

  28. Great Post! HERE is a post that talks about the WTO and the FSA agreement signed by Clinton in the 90s, this was the start of the financial meltdown and severely limits our government’s ability to create financial reform of any kind.

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