Financial Regulation and Fools

By James Kwak

Last week I disagreed with Paul Krugman’s dichotomy between limiting banks’ scale and scope and restricting banks’ risky behavior. Today Krugman has another op-ed, this time criticizing the current Senate bill for not being sufficiently “fool-resistant.” This time, I basically agree with him.

The problem with the Dodd bill, in Krugman’s words, is that “everything is left at the discretion of the Financial Stability Oversight Council, a sort of interagency task force including the chairman of the Federal Reserve, the Treasury secretary, the comptroller of the currency and the heads of five other federal agencies.” Citing Mike Konczal,* Krugman points out, “just consider who would have been on that council in 2005, which was probably the peak year for irresponsible lending” — Alan Greenspan, John Snow, and John Dugan. (If you’re following the logic of Krugman’s argument, those would be “fools.”)

The better alternative is to have hard-coded restrictions in the bill itself, to reduce agency discretion. I agree with that, and that’s why I think size caps should be in legislation — not just the power for regulators to set size caps.

Here’s how Krugman concludes:

“I know that getting such things into the bill would be hard politically: as financial reform legislation moves to the floor of the Senate, there will be pressure to make it weaker, not stronger, in the hope of attracting Republican votes. But I would urge Senate leaders and the Obama administration not to settle for a weak bill, just so that they can claim to have passed financial reform. We need reform with a fighting chance of actually working.”

But I’m not hopeful. First of all, this isn’t just about politics; as far as I can tell, Treasury Secretary Tim Geithner actually disagrees with Krugman and thinks that it’s better to leave things to the discretion of regulators. Here are Mike Konczal and Felix Salmon discussing Geithner’s position.

Second, it’s largely about politics. Bear in mind, I’m not a political consultant. But if I only cared about the politics of financial reform, not the substance, this is what I would do. The Obama administration doesn’t want to lose, say, 52-48 (that’s 52 in favor of the cloture motion, 48 against), because that’s a political liability; then they failed to reform the financial system, and they were blocked by a bipartisan coalition (41 Republicans and 7 “Democrats”), and the Republicans will say it’s because they were being too extreme. So I think they will do everything they can to get all 59 Democrats on board. Then they can say to Mitch McConnell: “Either you let us pass this bill, or you block it on a strict party line vote, which will prove to the country that you, the Republicans — not us Democrats — are in bed with Wall Street.” That’s a win-win situation; either they get their bill and declare victory, or they have a real issue to use in November.

But the cost of keeping 59 Democrats on board is a very, very weak bill — on TBTF, on derivatives, and on consumer protection. And that’s where I think this is heading.

Now, the administration could say, “This is a weak bill, but it’s the best we could get given the opposition, and we’re going to keep fighting in the future.” But I don’t think they’ll say that, because politically you want to have accomplishments, and calling your own bill a weak bill is like shooting yourself in the foot. So I think they will take the weak bill and declare victory.

* Can I point out again that Mike Konczal was our guest blogger before he was Ezra Klein’s? Krugman says that Mike’s blog is “essential reading for anyone interested in financial reform.” Mike, when you’re all famous, don’t forget us little people.

36 thoughts on “Financial Regulation and Fools

  1. On the politics, in a previous column, Krugman pointed out that it was ok to compromise on the Public Option to get healthcare through, but progressives should not accept a weak financial reform bill to get Joe Lieberman on board.

    I agree – a false sense of security is WORSE than continuing to keep Wall Street reform on Obama’s to-do list…

  2. Konczal will be like Truman Capote soon. Holding cocktail parties in Manhattan, writing books about the cloddish habits of his perennial friend James Kwak that Kwak thought were off the record….. (that’s a well-intentioned joke by the way).

  3. If they “take the weak bill and declare victory”, it might be because, by November mid-terms, there still won’t be much benefit to show for passing HCR, and unemployment will still be stubbornly high. They’ll need something they can frame as victory, even if it’s just a feeble start.

    I blame this jam on decimal number representation, or more specifically on what I call the $1.0E+12 problem. You can’t spend a trillion dollars even when you should (e.g., on the stimulus, or on getting HCR a rolling start). For now, “a trillion dollars” falls on most American ears as “a bazillion dollars”. Even though a trillion dollars isn’t nearly what it used to be, and the combination of growth and moderate inflation has give us a US GDP of about $13T.

  4. “The problem with the Dodd bill, in Krugman’s words, is that “everything is left at the discretion of the Financial Stability Oversight Council, a sort of interagency task force including the chairman of the Federal Reserve, the Treasury secretary, the comptroller of the currency and the heads of five other federal agencies.”

    The usual suspects.

  5. I’ve read a lot of the comments and read a lot of the books and thought long and hard about the issue of financial regulation. My reluctant (I’m a Galbraithian at heart) conclusion: Its history shows that all attempts to regulate ultimately fail for one reason or another, whether through regulatory capture, inadequate penalties, loosening or repeal of relevant laws, or the introduction of moral hazard into the system.

    Let’s look at the wreckage of the latest financial crisis:

    1. Fannie Mae and Freddie Mac, once quasi-private mortgage guarantors, now dependent upon the full guarantees of the government.
    2. FASB changes the rules when companies get into financial difficulty.
    3. SEC sleeps soundly in spite of Harry Markopolos ringing the alarm about Bernie Madoff for 8(!) years.
    4. Debt rating agencies rate junk AAA and lose what credibility they had.
    5. FDIC effectively insolvent.
    6. Federal Reserve falls down in its role as lender-of-last-resort.

    One thing the above failures have shown me is that our financial safeguards seem to work only when they’re not needed. So why bother having them at all? They merely create the ILLUSION OF SAFETY, aka MORAL HAZARD.

    Perhaps the best our financial overseers can do is to act as repositories of information, said information being easily available to all. In other words, aim for the free-market ideal of total transparency. And then warn depositors and investors that yes, there is risk in giving their money to someone else but no, they won’t get it back if they make a bad decision.

    I know this sounds utopian. But to me it sounds a whole lot better than a financial system of regulations piled upon regulations piled upon regulations; all in constant need of revision, updating, and fine-tuning because the sharps of Wall Street are running through or around them.

  6. trouserman wrote:

    “I’ve read a lot of the comments and read a lot of the books and thought long and hard….”

    “What the world is today, good and bad, it owes to Gutenberg. Everything can be traced to this source, but we are bound to bring him homage, … for the bad that his colossal invention has brought about is overshadowed a thousand times by the good with which mankind has been favored.”

  7. Greenspan Says His ‘Friends’ Got The Financial Crisis Right – And Trades Barbs With Michael Burry (VIDEO)

    04-5-10 02:39 PM – Huff Post – excerpt

    “In a New York Times op-ed yesterday, Michael Burry, the reclusive hedge-fund manager profiled in Michael Lewis’s best-selling “The Big Short,” lambasted former Federal Reserve Chair Alan Greenspan and his colleagues, claiming that they “either willfully or ignorantly aided and abetted the bubble.”

    Burry, who was trained as a medical doctor and suffers from Aspberger’s syndrome, placed huge bets that the subprime market would collapse and helped make his investors many millions.

    Greenspan responded to Burry’s op-ed in an interview on ABC News’s “This Week,” where he told Jake Tapper that while almost everyone failed to predict the implosion of the subprime market and while some people predicted it by chance, there was a “very small group, most of whom are my friends, who got it right, for the right reasons.” Burry, he said, may well have been one of those people:

    In an appearance on Bloomberg Television last week, Greenspan insisted that Burry’s successful prediction of the subprime crisis was a “statistical illusion.”

    Burry, for his part, says that Greenspan “should have seen what was coming and offered a sober, apolitical warning.”

    But that’s not what happened. And, peculiarly, in the years since the subprime market imploded, Burry says policymakers have shown little interest in understanding how or why he was able anticipate the timing of the crisis with such accuracy. Rather than a simple dismissal of those who got it right, Burry argues:

    “Mr. Greenspan should use his substantial intellect and unsurpassed knowledge of government to ascertain and explain exactly how he and other officials missed the boat. If the mistakes were properly outlined, that might both inform Congress’s efforts to improve financial regulation and help keep future Fed chairmen from making the same errors again.”

    ”If I have made myself : clear, I have mis-spoken.”

    Alan Greenspan

  8. I think you can’t blame the FDIC if Summers/Geithner decided they weren’t going to use the resolution authority. In my personal opinion (other than Sheila Bair getting her mortgage on a home she was using at least partly as a rental) FDIC is one of the few players on this comes out smelling not so bad. And I’m guessing as FDIC sells off those assets in the auctions (hopefully public auctions) the FDIC balance sheet won’t be so bad.

  9. All this back and forth over correct legislation or what the bill should seek to do is just a pointless attempt to re-invent the wheel. I say bring back Glass-Steagall and be done with it.

  10. Rev. Billy Talen ARRESTED After Placing ‘Holy Hex’ On JPMorgan

    04-5-10 05:40 PM – Huff Post – excerpt

    “A New York City preacher has been arrested for placing a ‘holy hex’ on JPMorgan Chase.

    “Rev. Billy led his Life After Shopping Gospel Choir to two East Village Chase branches, where the singers “deposited” mounds of “sacred dirt from Coal River Mountain, West Virginia” on the floors of ATM lobbies.”

  11. Who of all regulators and experts shouted out that the credit rating agencies should not be trusted as much as they were by the regulators and that sooner or later they would lead us over some type of cliff?

    Who of all regulators and experts shouted out that you should not arbitrarily discriminate based on perceived risk of default what was already discriminated in the markets for exactly the same reason, without messing up the capital allocation mechanisms of the market?

    Almost none did, and most do still do not even understand what went wrong, so save us from dividing regulators and experts in the good or the bad given that they are all basically plain lousy fools.

    Look what they’ve done to my bank Ma!

  12. Consumer protection may not be a good thing to pursue if it is the stumbling block. Who reads all those forms they ask you to sign for a new mortgage now? How can they stop every conceivable way of slipping in extra costs without severely curtailing the products that can be made available?

  13. 13 Bankers points out that governments always bail out at least some of the oligarchs because of personal relationships, and the politicians need them to stay in power. Such rings true to me. So I doubt if the necessary step of letting them fail will prevail. And leaving bemouths existing leaves us in too much danger. Someone posted incentives recently that they thought would motivate the TBTFs to downsize. That would be the best approach, I think, since the principles of the TBTFs probably would know the least damaging way to bring it about.

  14. I read that simplicity and transparancy would be a good start. That is what the the Consumer Financial Protection Agency was to be about. And it is why it is being nutured.

  15. I am just as cynical as you, James, and it still saddens me that you are right about the politics of effective financial reform. The only difference is that I have a vague hope that the members of the Capitol Hill Club (our legislators) are actually aware that voting against strong reform is counter to the broad (and I mean perhaps 95% broad) public concensus that is sick and tired of our country being owned by the financial elites. It will really come down to who gets the best message out and stands hard on it. If I were President, I would make it clear that those who visited the White House and promised their cooperation are still working hard not to help, and that a very strong bill is what they deserve. I say go for Glass-Steagall and damn the torpedoes. But then I’m not bought by lobbyists and campaign funding.

  16. I love Rortybomb, but …

    “(3) “If you put this in the bill you will be responsible for another Fannie and Freddie” is so ridiculous I don’t even know where to begin.”

    Strawman, much? Mr. Konczal, Geithner only said that Fannie/Freddie’s relatively stringent leverage ratio requirements didn’t save them in the end. Necessary but not sufficient. He wasn’t prospectively blaming anyone. No need to put words in his mouth.

    Some interesting Dugan v. Geithner here:

    with Dugan saying the U.S. will “never surrender sovereignty” in these matters, and Geithner basically saying the U.S. has to. Not all Dubya-holdovers are alike.

    As Krugman analyzed it, you had a very rapid international contagion because of international interlock in financial markets, combined with high leverage. There is no drawbridge for capital. A regulatory framework that would work for the U.S. (if it were the only significant economy) but that doesn’t also apply to the rest of the developed world is little more than a rhetorical setup for exporting blame when the next crisis hits.

    Geithner might be “captured”, but that doesn’t make his basic point wrong: leverage ratios should probably conform to an international standard to be effective; unilateral U.S. legislation can only work if regulators around the world adopt the U.S. leverage ratio formulae as a de facto world standard. Will they? I doubt it.

  17. A better start yet would be to eliminate those incentives that act like growth-hormones for the TBTF… like the discriminating capital requirements that favors the kind of business the TBTF do.

  18. “But I’m not hopeful. First of all, this isn’t just about politics; as far as I can tell, Treasury Secretary Tim Geithner actually disagrees with Krugman and thinks that it’s better to leave things to the discretion of regulators. Here are Mike Konczal and Felix Salmon discussing Geithner’s position.”

    Um, Geithner was the NY Fed guy; IIRC, the Wall St people got to vote on his initial appointment; he rewarded them by making sure that the bailout was as generous as possible. It *IS* about politics.

  19. Break financial reform measures into separate bills: breakup of banks; control of derivatives; consumer protection agency; regulation of financial activity that could cause future debacles.

    Argue each part to the public as as a separate entity so that cogent understandable arguments can be made, that the public can understand and think about.

    Pass what can be passed and then go back re-mount arguments on what didn’t get passed. Keep making well defined arguments that regular people can become aware of and understand.

    As the public becomes aware of “what and why” regarding financial reform, make them aware of why the looters and the Republicans are fighting against the reform.

  20. This article says NYC may get hit. I am trying to get a job in finance so this may not bode well for me.

    Article can be found at

    Good, bad & ugly in financial reform

    By Kathryn Wylde

    Published: April 4, 2010 – 5:59 am

    With health care out of the way, regulation of the financial industry tops the reform agenda in Washington. New York has a lot on the line.

    The financial industry employs 530,000 New Yorkers and generates another 1.5 million jobs in other sectors, contributing $200 billion a year to the region’s economy. The city stands to gain from bipartisan reform that restores confidence in the U.S. financial system and puts public outrage over bank bailouts behind us.

    The starting point for debate over reform is a bill introduced last month by Senate Banking Committee Chairman Christopher Dodd. It directs regulators to toughen bank reserve requirements, authorizes more comprehensive and rigorous oversight, amends the bankruptcy process to provide for the orderly shutdown of troubled firms, and establishes strict new oversight of derivative products.

    These measures are all needed to avoid another collapse and limit taxpayers’ exposure.

    But the Dodd bill also contains proposals that could seriously damage New York’s finance-based economy without making the American financial system better or safer. For example, the “Volcker rule,” named for a venerable New Yorker, would seek to turn the clock back to an era when the financial industry was less integrated and less global. Breaking up big banks or limiting their lines of business would not prevent another crisis, but simply make U.S. institutions less competitive with their foreign counterparts.

    Punishment seems to be the rationale for a Dodd provision that would threaten the viability of credit rating agencies by exposing them to huge litigation liabilities, risking thousands of local jobs and chaos in the bond markets.

    Another provision would allow states to override federal consumer protection regulations and give state attorneys general the ability to enforce federal laws based on 50 different interpretations. This would make it more difficult and expensive for New York’s national banks to compete in local markets and defeat the goal of establishing one clear set of rules that can be easily monitored and enforced.

    Finally, Dodd would strip the Federal Reserve Bank of New York of its authority over hundreds of financial institutions and make its president a political appointee. The New York Fed is the anchor of New York’s financial district, managing some $7 trillion a day in international payments and foreign exchange. Reducing its supervisory role and undermining its independence from politics constitute significant blows to America’s stature among the central banks of the world.

    Other congressional committees are contemplating new taxes on large banks—taxes that would drain their coffers just when they need to put their capital to work making loans to small businesses, financing home purchases and restarting the construction industry.

    More federal bank taxes translate into a multibillion-dollar reduction in New York’s state and local revenues.

    We need financial reforms that strengthen the industry. We should vigorously oppose actions that would threaten our status as a world financial capital and weaken the U.S. position of leadership in the global economy.

    Kathryn Wylde is chief executive of the Partnership for New York City.

  21. You need to combine that with a certain uniformity of standards for financial products and strict enforcement of those standards without respect to persons.

    Otherwise you get something like what happened to depositors in many failed and failing Ukrainian banks: the rich, powerful and connected got their money back at the expense of the savings of pensioners and small savers.

    Even from the point of view of the bank, this is an entirely rational choice, as in a system where there is no rule of law, you do not want to piss off the rich, powerful or connected.

  22. & yes, we will have depressions like we used to, esp. 1929-1942. Only when WWII mobilized the labor resources of the U.S., did it get out of that beast’s clutches. The reason why the U.S. did not have the same problem since (except 2006+) was because the U.S. under Truman adopted a constant war-making footprint, ie, “global power with global responsibilities.” Had Truman dissolved the armed services in 1945 as had been done in the past, the economy would again have slid into a deep recession, just like it did after Korea and Viet-Nam.

  23. So we’re back to square one (rather your earlier post replying to Krugman): given the political reality of a weak bill, what’s the sequencing. First try to get TBTF or go after some other fool proof provisions (eg, capital requirement,etc.)?

  24. I was listening to NPR’s “The Giant Pool of Money” again and there is a segment where they interview a mortgage salesman in Nevada that sold mortgages to major investment corporations. What struck me about his interview was where he mentioned that when 1 investment bank would lower their credit standards so they could purchase more higher risk mortgages then the others would follow suit in a herd-like mentality. Then today I read about Bernanke saying how well it will work to take 1 big financial corporation into bankruptcy…..but that’s not a realistic scenario about how these financial meltdowns play out.

    It was not just 1 financial corp. in trouble, it was the whole “herd” that copied each other’s bad practices in an effort to make greater and greater profits. History has taught us that financial panics don’t just drive 1 financial corporation to bankruptcy, it drives them all to the brink, because they all follow the same flawed business practices….everyone dancing while the music is playing. What someone needs to ask Mr. Bernanke is how the bankruptcy process will work when the whole system fails and multiple, large financial corporations are failing simultaneously. It appears to me that once again the US taxpayer will be called upon to drive the financial corporations home from the dance to make sure they get home safely.

    Here’s a link to NPR’s “The Giant Pool of Money” in case anyone wants to listen to it.

  25. Just to make my earlier post more to the point. All your posts are thoroughly convincing on what needs to be done. What we need now – given the various constraints surrounding the passing of the bill – is a ranking of priorities, ie, what is number one, number two,….. In other words, where does TBFT in the pecking order. Krugman would argue, if I understand correctly, that the depression tells that TBTF is not number one (even small banks lead to catastrohpies if they act alike), capital requirements, regulation/compratimentalisation of functions is more important. What’s your take?

  26. Let me quote the critical part because without the credit rating agencies no one would have purchased one single of these lousy mortgages:

    “Alex Blumberg: To be fair, they knew there were risks. But investors have a system to assess those risks. They’re these special companies. Credit rating agencies. Moody’s, Standard & Poor’s, Fitch. Their job, their main job, is to assess risk for Wall Street and the global pool of money. They rate every kind of bond according to its risk. Triple A is the safest, then there’s double A, single A, all the way down to single B and below.

    And that’s all most investors look at – the letter grade. They trust the credit rating agencies. And these agencies blessed most of these mortgage-backed securities. Gave them AAA ratings – which means they were considered as safe as a US government bond.

    This was the magic of this whole system. You could take a pool of thousands of risky mortgages, and create a security that was called money-good, as safe as any investment out there. At least that’s what people thought.

    But now we know those agencies relied on the wrong data. That same historic data that had nothing to do with these new kinds of mortgages.” End of quote.

    BUT for you all to understand it better you have to realize that the worse the credit the higher the rates and so the bigger the difference between these and what normal real AAA rated operations paid and so the larger the profit when discounting long term mortgages awarded at high rates using low rates.

    And all this nonsense the courtesy of our regulators who established that if a bank bought these securities collateralized with mortgages and rated AAA they needed only 1.6 percent in capital… in other words they authorized the banks to leverage themselves 62.5 to 1… and these regulators are not even made to wear a cone of shame but are still acting as regulators.

  27. What a surprise from Kathryn , CEO of The Partnership for New York (PNY). I wonder if she discussed a draft of her comments with the co-chair of PNY, Llyod C. Blankfein. How interesting. More of Kathryn & Llyod’s interconnecting relationships can be seen in the interactive, e.g.

  28. Are you following the news on pension funds that have tried to sue the ratings agencies? Some news from Bloomberg about this issue.

    April 6 (Bloomberg) — Standard & Poor’s, the McGraw-Hill Cos. unit facing increased regulation after flawed assessments of mortgage bonds, is enlisting Republican lawmakers to kill legislation that may make it easier to sue credit-rating firms.

    Senate Banking Committee members Bob Corker of Tennessee and Judd Gregg of New Hampshire are being asked to help defeat a proposal that may make judges less likely to dismiss lawsuits against ratings firms, McGraw-Hill lobbyist Cynthia Braddon wrote in a March 22 e-mail to congressional staff members.

    The banking panel approved legislation last month that includes the liability measure as part of a sweeping plan to tighten regulation of Wall Street. Republicans could force Democrats to drop the provision in exchange for votes needed to ensure passage of the broader rules overhaul, according to a copy of Braddon’s e-mail obtained by Bloomberg News.

    Democrats “cannot bring this bill to the Senate floor” unless it’s supported by Republicans, Braddon wrote in the e- mail. The liability of credit-rating companies “remains a bone of contention,” she wrote.

    Public pension funds say S&P and Moody’s Investors Service helped cause the global financial crisis by giving top rankings to mortgage bonds after receiving fees from banks to rate the assets. The blame isn’t guaranteeing legal victories, a point underscored March 31 when a federal judge in New York dismissed a suit accusing S&P and Moody’s of defrauding investors who relied on their ratings before buying $63 billion of securities.

    A similar suit filed by investors who bought $100 billion of mortgage-backed securities was dismissed in January.”

    Read more:

  29. Observer wrote:

    “Are you following the news on pension funds that have tried to sue the ratings agencies?

    April 6 (Bloomberg) “Standard & Poor’s, the McGraw-Hill Cos. unit facing increased regulation after flawed assessments of mortgage bonds.”

    Thanks Observer, interesting.

  30. That’s an excellent start Chad. Between the Fed and Treasury we’ve spent upwards of $24 trillion bailing out banks less the lunch money for the automakers. Meanwhile the jobs bill is a miserly $15 billion. Call him Bush, call him Obama, it’s still Mr. Potter to me.

    Robert Reich noted in an OpEdNews column yesterday:

    The direction financial reform is taking is not encouraging. Both the bill that emerged from the House and the one emerging from the Senate are filled with loopholes that continue to allow reckless trading of derivatives. Neither bill adequately prevents banks from becoming insolvent because of their reckless trades. Neither limits the size of banks or busts up the big ones. Neither resurrects the Glass-Steagall Act. Neither adequately regulates hedge funds.

    More fundamentally, neither bill begins to rectify the basic distortion in the national economy whose rewards and incentives are grotesquely tipped toward Wall Street and financial entrepreneurialism, and away from Main Street and real entrepreneurialism. It was just reported, for example, that America’s top 25 hedge fund managers last year earned an average of $3 billion each. They continue to pay a federal income tax of 15 percent on most of that, by the way, because their lobbying efforts have been so successful.

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