Financial Reform for the Long Term

By James Kwak

The news these days is largely about the financial reform bill on the floor of the Senate. I think you know my opinion about that: many good things, not enough to solve the root problems, but still better than nothing.

Here’s a simplified way of thinking about things. There are two general problems with the financial sector today, which were the subject of two consecutive columns by Paul Krugman. The first problem, according to Krugman: “Much of the financial industry has become a racket — a game in which a handful of people are lavishly paid to mislead and exploit consumers and investors.” This is what we see in the SEC-Goldman suit, the Magnetar trade, and so on. The financial reform bill is largely (but not exclusively) aimed at this problem; that’s why there are a consumer protection agency, new trading and clearing requirements for derivatives, etc. These reforms, I think, have a reasonable chance of doing good.

The second problem, again in Krugman’s words:

“The reforms currently on the table . . . only deal with part of the problem: they would make finance safer, but they might not make it smaller. . . .

“We’ve been devoting far too large a share of our wealth, far too much of the nation’s talent, to the business of devising and peddling complex financial schemes — schemes that have a tendency to blow up the economy.”

This is the long-term challenge (see my charts here). Finance is an intermediate input. At the margin, every little innovation that makes markets more liquid does provide a small benefit to the economy in the form of better capital allocation; but in many cases those benefits are not enough to justify their transaction costs, let alone the negative systemic externalities we saw recently. The flowering of finance in the past three decades gave us the illusion of growing real GDP — especially in the past decade, when GDP growth was dominated by finance and real estate. Now we need to rebalance the economy toward productive activities.

The bad news is that the administration and Democrats in Congress will face a strong temptation to pass the reform bill and declare victory. The conventional wisdom is that you don’t get re-elected by saying, “We passed a bill that is pretty good, but doesn’t solve the root problems, so we need to do more in the future.” It’s better politically to say you fixed the problem once and for all, then cross your fingers and hope for the best.

The good news is that there seems to be a growing number of voices saying that we need structural change in the financial sector. Besides Krugman and Arianna Huffington, Martin Wolf has chimed in as well, arguing that making the current system safer, though necessary, is insufficient:

“The financial system would remain a doomsday machine. There are three difficulties. First, there is no sound basis for deciding how much capital is enough. Second, . . . it is profitable to take risks whose upside accrues to oneself and whose downside accrues to others. So the safer regulators try to make the system, the more risk it can take on. Finally, it is easy to create the desired risk via regulatory arbitrage.”

Serious academic economics is also questioning the value of a large financial system. A paper by Nicola Gennaioli, Andrei Shleifer, and Robert Vishny (cited by Krugman here) shows how excessive production of securities (the phenomenon of the past decade) can be caused by mistakes in risk perception, making the financial system more fragile as a result. (As a another result, the social benefits of innovation can be outweighed by the social costs.)

So in the long term, I agree with Krugman: “These [current] reforms should be only the first step. We also need to cut finance down to size.” Given that whatever comes out of Congress will be imperfect in anyone’s eyes, whether the Obama administration agrees will be of crucial importance.

86 thoughts on “Financial Reform for the Long Term

  1. Great post.

    “We must make finance smaller” seems like a more extreme case of “Banks must not be too big to fail.” Given that we haven’t successfully tackled the latter (and that if we did, the former might no longer be true anyway), it feels like we’ve skipped a stage here (and also moved away from a market-based solutions)….

  2. “Besides Krugman and Arianna Huffington, Martin Wolf has chimed in as well, arguing that making the current system safer, though necessary, is insufficient…”

    Yeah, but so what, these are hippie-libs, and don’t want [superman voice]FREEEEE Markets![/superman]

    The progressive side will yell, shout, point out flaws and errors, and in the end, end up disappointed and pushed aside, as They have been since the 70’s.

  3. I’m a big fan of Krugman, but I think you tread too lightly with him here. This is the guy that is claiming that TBTF is not an issue of bank size, and then using Canada’s massively subsidized, government dominated banking sector as an example of big banks that work and are “good”. This is highly disingenuous, and you should be calling him to account, not amplifying his megaphone.

  4. Oh, and one more thing, Harvard economists don’t help with the debate either. Come back when a serious group that the media pays attention to, such as the Heritige Institute releases a paper, or you know those all important policy papers. what are they called again? Oh yeah, Public polls.

  5. My take on Krugman is that he is merely stating that concentrating on bank size only doesn’t solve the problem. I wish James K and Simon would address Long Term Capital Management – it was not a TBTF bank. Maybe they have already done this but as I remember this was another institution that nearly brought what is laughingly called a system down. On another note why do some think it is wrong to shape the system to our needs not the bankers needs to amass more power and wealth.

  6. Indeed, Krugman is inconsistent here and should be called to task. But step back a minute. His larger comment is correct – the financial industry has gone far beyond its proper economic role of allocating capital efficiently to productive endeavors. In engineering speak it has been functioning as a resonating chamber for at least 2 decades, skimming a lot of paper profits off of circular transactions. The unfortunate short term effect of a reduction in the financial segment would be a significant drop in the Dow, though…too bad for us boomers. But our grandkids would appreciate the more concrete economy that we would leave them.

  7. “It would be better than nothing”, alas. The real issue that must be observed is the factors that motivate gambling. It is human nature to gamble, and it is human strength to know when it is not appropriate.
    As we watch those that play with money as though it were anything but a concept, we should sit back for a moment and question if it is all gambling.
    Because we do not take care of the foundation, we destroy the roof. Because you are willing to gamble using the concept of mathematics, you exhibit tendencies that clinical psychology has well known descriptions.
    Because it is allowed, you have the power to destroy a world.

  8. “The great American experiment in democracy will work so long until the people find out they can raid the treasury.” Alexis de Toqueville, 1805-1859.

    “Until the public policy of privatizing profit and socializing loss ends, we are an oligarchy.” Me, 1953-

  9. Devil’s Advocate question: Besides the political power of TBTF banks that is often cited for Obama’s lack of desire to break them up, are there other reasons why a “reasonable” President would not want to break them up? For example, can a Goldman Sachs, for example, come in handy in engaging in “economic warfare” where smaller banks would not be up to the job. I define “economic warfare” as serving a particular nation’s vital national interests. Could dismantling TBTF banks be seen as somewhat equivalent to dismantling our armed forces? Just askin’.

  10. Mr Krugman wrote: “Much of the financial industry has become a racket — a game in which a handful of people are lavishly paid to mislead and exploit consumers and investors.”

    May 4 (Bloomberg) — Goldman Sachs Group Inc.’s employee morale remains good and Chief Executive Officer Lloyd Blankfein received a standing ovation from partners at an April 20 earnings call, analyst Brad Hintz told clients.

    The firm estimates that about 75 percent to 80 percent of derivatives that are currently traded over the counter will move on to exchanges as the result of new regulation, Hintz said. The rest are the “highly profitable, tailored segment” of the business that will, under the current version of the Senate bill, have to be originated outside of the company’s regulated bank subsidiary, Hintz said.

    Goldman Sachs is also planning a “fair amount of hiring” in every part of its trading business this year…”

    The song remains the same.

  11. Maybe I should give my name as “Johnny One-Note”.
    For, after a couple of posts in F-sharp-minor
    and Lamda-flat, I return to C major. Once again:


    This is about what Mr Kwak, finally, is calling for, no?
    We all criticize and carp, and occasionally a suggestion
    is made that seems useful(maybe we shouldn’t have TBTF
    banks), but I’m looking for a theory of what kind
    of financial system an American capitalist system
    should have.

    I gave from first tentative inadequate thoughts a
    while back(I am a mathematician, not an economist)
    so I’ll be very short, just enough to kick off the

    Banks: they generate money in our society. MONEY
    IS IMPORTANT. Therefore banks are important and
    should be carefully run and carefully regulated.
    They take care of my and your money(who nowadays
    wants to pay cash for everything?), and they loan
    it out, to me, for my house and my car, and to
    businesses. What else should banks do?

    Insurance companies: a slippery slope here. I
    want to insure against the possibilit that my
    house burns, or that I run over a nun pushing a
    baby carriage. I shouldn’t be allowed to “insure”
    the security of _your_ house. If I’m allowed to do
    so, I might be tempted to torch your dwelling,
    giving myself a nice payoff.

    Etc etc. We should start, as I do above, with
    the obvious. We can get fancier as new and cleverer
    entries show up.

    What about it, folks?

    Best wishes,

    Alan McConnell, in Silver Spring MD

  12. Two Words: Glass-Stegal.

    We wouldn’t be having this inane conversation about how important banks are if we could separate the BANK parts of banking (using stored money to make loans to businesses that need it), and the gambling side of banking. There would be riots in the streets if a Gambling institution was bailed out by the Government for paying out too much. We’ve been convinced of the idea that these institutions are important to grease the gears of society, because after all, banks are important. I fail to see an answer to this problem that won’t arise again without making banks Bank again.

  13. Simple Banks need not reinvent themselves,nor generic Investment Banks. This is not their function,period!The macro,and micro business world is made up of imaginative entrepreneur’s via innovation. They are america’s collective,and unique genius that foster growth. The “Law of Large Numbers” explicitly states that over time new enterprise must enter the markets to foster growth, and “Not” piling garbage upon garbage to sustain a growth product now a commodity. This is/was the basic business model for decades, but unfortunately has been hijacked by K-Street. PS. There’s so much more,but in all honesty it comes down too “KISS”. Thanks

  14. Krugman finally making sense again. FINALLY. Yes, size is a freaking problem. It’s a BIG problem (pun very much intended). Maybe his opinions finally, jelled, cemented, or “coagulated” or whatever…. Of course Krugman’s huge monster size Ego will say he was here all the time. Whatever. It doesn’t matter. Generally, I like Krugman and it’s good to see he’s on the right team instead of making unnecessary cheap shots. See here:

  15. Alan,

    I think there is an issue whenever one tries to visualize something “ideal,” since the term itself is somewhat subjective. To some, the “ideal” is a world that doesn’t need a financial system at all (e.g., David Harvey). To others, it means that any intrusion by non-market actors (like governments) creates distortions that lead to negative consequences.

    My own opinion is that regardless of how the “Financial System” is structured, as long as our economy is primarily fueled by debt we are going to have instability. This is the paradox: without debt, we will have no (or very little) growth; but with debt, if the growth is insufficient the enterprise collapses.

    We probably ought to think about limiting debt of all kinds, and just live with the lower growth (which many would be unhappy about). By limiting the total amount of debt, we would force finance to focus on efficiently allocating capital. In today’s world, with lots of debt, it is more profitable for finance to expend its energy trading that debt. (Shrink the pool of debt, shrink the size of the bond market — simple).

    This would, of course, entail governments large and small refraining from issuing new bonds (more debt), forcing them to defer spending and maintain budget surpluses (putting even more restraint on growth). As a side effect, however, it would be very difficult to sustain wars.

  16. CFPA will help consumers, but there is a need to limit the risk in securitization market. As the CDO market has showed already, even a single bad loan can be packaged into umpteen number of CDO’s to spread risk or aptly to make steal more money from others! This behaviour needs to be prevented and regulated..

  17. I disagree. We already bailed out a huge casino. There wasn’t even widespread vehement protesting, much less rioting.

  18. OK, EngineerThreeCubed, back at ya! You are of
    course right about “the ideal”. Who knows it, who
    can reach it? But ya gotta have a theory of what
    we are working toward, no? Otherwise we are simply
    locked in a dark room, slashing at snakes as we feel
    them slithering towards us. What do we want? That
    is maybe a hard question; but we can/should use this
    fine blog to make a stab at some tentative answers.

    In the matter of “debt”, again you are right. What
    a dangerous and crazy concept! But we surely need
    _some_ debt, no? why should a productive young
    engineer, or mathematician, have to wait thirty
    years before (s)he has saved enough to buy a house?
    Why can’t I have a credit card, borrowing every
    month from my bank(I always pay my one card off
    each month)

    Is not debt like water? Too little -> desert, no
    life, nothing can exist. Too much -> a howling
    storm at sea, we’ll all drown. So I read your
    post as calling for a Happy Medium, a Goldilocks

    Re your last sentence: let’s get the idea of a
    socially useful financial system worked out. Then,
    from a position of strength, we can convince the
    rest of our country(wo)men to adopt our ideas. Then,
    flushed with success, we can work on elminating
    war. (I would put a grin emoticon here, but the
    editor wipes any such out)

    I hope for other comments. Let’s stop slashing at
    snakes in the dard; let’s turn on the light.

    Best wishes,

    Alan McConnell in Silver Spring MD

  19. The “Consumer Agency” rules can be vetoed by 2/3rds “the Council”. The Council has only one rep from the Consumer Agency. The rest are political appointees of various agencies. The Consumer Agency is not independent, at all. If the president is bank friendly, the Consumer agency is toothless.

    I read the text of the bill this morning. Anyone see something I’m not?

  20. Hang in there, Alan. You left out Peterson, though, (unless he’s f#).

    Look, all, “Ideal” doesn’t have to mean pie in the sky, happy times are here again forever. It means nailing down what it is we want to end up with after we’ve finished doing what we have to do to get there between now and then. Or words to that effect.

  21. Re: @ gd____Sheila Bair (FDIC) on “Banks and Swaps” is OK with it,…just needs some tweaking! Come one, come all,…as you said,”umpteen” is so politically correct. Whoa,Nellie!

  22. Krugman doesn’t day bank size is irrelevant. What he _does_ say is that reducing the size of big banks won’t make the system safe. Even small bank failures can put the system at risk; he cites the early 1930’s as evidence.

  23. Didn’t mean to step on you there, Alan, your answer to engineer27 post hit while I was finishing mine and I didn’t check. Sorry.

  24. “Until the oligarchy ends, we will be privatizing profit and socializing loss…”

  25. Just alittle off topic? Please hear me out. Conspiracy,you be the judge? JP Morgan Chase starts a vicious,and unfounded rumor that Bear Stearns (the Investment Bank they need to make them whole) is having equity,and financial problems. Bingo the herd sells off Bear Stearns,and the “White Knight” JPMC comes to the rescue ,and actually pays 5x more than what they actually could have gotten the entity for (beware of Greek’s baring gifts,no pun?),but what comes next should raise some eyebrows! Next,we have shortly after,…another vicious rumor floating around that WAMU is having financial problems (totally unfounded),and again the herd pulls the plug,and the company goes belly up in just weeks. Who do you think is the White Knight? You got it,JP Morgan Chase,and gobbles them up for pennies on the dollar! A huge coup for the Conglomerate. Coincident? Now back to what’s happening in the Eurozone with the “PIIGS”s. It was the same Moody’s,and S&P Rating Agency that rated all the CDO’s,CDS’s,MBS’s,ABS’s,and R&CMBS’s that caused the financial meltdown in America. Now these outstanding trust-worthy rating agencies are running amuck in Euro-Land down grading (or threatening to) at will, all the PIIGS’s! Kind of funny,but really sad when you think about it. Mind you its only the Eurozone taking the hit now ,which begs me to differ? How does the “Great British Empire”, “Not” get put under the microscope of fiduciary worthiness oversight,ie)Royal Bank of Scotland,and Barclays plc?

  26. Re: @ Anonymous____Some Federal Agency can be over-ruled by the “Secretary of the Treasury” if deemed necessary. Not quite sure which agencies or committee’s are envolved? Need some help here.

    SEC. 1024. .
    (a) Review of Bureau Regulations- On the petition of a member agency of the Council, the Council may set aside a final regulation prescribed by the Bureau, or any provision thereof, if the Council decides, in accordance with subsection (c), that the regulation or provision would put the safety and soundness of the United States banking system or the stability of the financial system of the United States at risk.

    (3) VOTE-
    (A) IN GENERAL- The decision to issue a stay of, or set aside, any regulation under this section shall be made only with the affirmative vote in accordance with subparagraph (B) of 2/3 of the members of the Council then serving.

    (A) EFFECT OF DECISION- A decision by the Council to set aside a regulation prescribed by the Bureau, or provision thereof, shall render such regulation, or provision thereof, unenforceable

  28. (1) VOTING MEMBERS- The voting members, who shall each have 1 vote on the Council shall be–

    (A) the Secretary of the Treasury, who shall serve as Chairperson of the Council;

    (B) the Chairman of the Board of Governors;CommentsPermalink

    (C) the Comptroller of the Currency;

    (D) the Director of the Bureau;

    (E) the Chairman of the Commission;

    (F) the Chairperson of the Corporation;

    (G) the Chairperson of the Commodity Futures Trading Commission;

    (H) the Director of the Federal Housing Finance Agency; and

    (I) an independent member appointed by the President, by and with the advice and consent of the Senate, having insurance expertise.

  29. Obama already abandoned the $50 billion bank fund, paid for the banks.

    I just hope he sticks to his guns and makes the consumer agency a real independent agency. Putting it with the Fed is a total joke.

    And I hope he sticks to his guns regarding the derivatives. Keep them for companies with a business interest–consider it like the “insurable interest” principal. And many if not most of those can be cleared in a public exchange anyway. OTC ones need to be registered beforehand with regulators who are charged with keeping track of leverage exposures.

    As for Glass Steagall II, I’m all for it but it doesn’t seem to be getting enough traction at the moment. Too bad because no one considers the cost of instability. We’ve just seen what extreme instability can cost–trillions in dollars, millions in jobs.

    In contrast stability must be good for markets overall. How many times have you heard business people complain about how “uncertainty” hurts business? Has any economist done a study indicating what instability costs?

    Traders love it. But they call it volatility. That’s the casino mentality and it’s infected all securities trading.

  30. You had to implicate the FDIC as well in the case of WAMU. My ears are open. JPM wanted to buy WAMU for years…

    I think the gov made a decision that some banks were systematically more important than others. JPM was one. The others’ blood (depositors and assets) would feed these banks. Perhaps even well placed swaps or wrongly written swaps. Outcomes were geared to save particular banks. That’s why the outcomes (like Bear and Lehman) don’t look logical on the outside.

  31. James, I hope you write about this Potomac two-step in terms of the Consumer Protection agency. Look at the Council. That will be the most politicized lobbied Council in American history. It’s also spreading out the blame among all the agencies, so people can hide politically behind the decisions. The buck doesn’t stop here. This is a political game to hide to buck.

    I’m very disappointed in Obama. This is not what was promised, even after Dodd broke off the “negotiations”. Its even better for banks now than before.

  32. EFFECT OF DECISION- A decision by the Council to set aside a regulation prescribed by the Bureau, or provision thereof, shall render such regulation, or provision thereof, unenforceable

  33. More power to Fed from OTS. Is this a good idea?


    (A) BOARD OF GOVERNORS- There are transferred to the Board of Governors all functions of the Office of Thrift Supervision and the Director of the Office of Thrift Supervision (including the authority to issue orders) relating to–
    (i) the supervision of–
    (I) any savings and loan holding company–
    (aa) having $50,000,000,000 or more in total consolidated assets; or
    (bb) that is a foreign bank; and
    (II) any subsidiary (other than a depository institution) of a savings and loan holding company described in subclause (I); and
    (ii) all rulemaking authority of the Office of Thrift Supervision and the Director of the Office of Thrift Supervision relating to savings and loan holding companies.

    Under 50B goes to OCC

  34. Alan McConnell wrote, May 5, 2010 at 1:38 pm:

    “Maybe I should give my name as “Johnny One-Note”.
    For, after a couple of posts in F-sharp-minor
    and Lamda-flat, I return to C major. Once again:


    Alan, we the guests, post at the pleasure of Mr. Kwak and Mr. Johnson, they perform a valuable service. Baseline Scenario is a buffet of information. The answer is different for everyone. The information is flowing.

    I learn as much from the folks I disagree with as those I agree with. If dreams are not beyond ones grasp then what is heaven for?

  35. (A) BOARD OF GOVERNORS- All rulemaking authority of the Office of Thrift Supervision and the Director of the Office of Thrift Supervision under section 11 of the Home Owners’ Loan Act (12 U.S.C. 1468) relating to transactions with affiliates and extensions of credit to executive officers, directors, and principal shareholders is transferred to the Board of Governors.

  36. Based on my Wall Street experience, I don’t expect Goldman Sachs execs to do any jail time

    Saturday, May 1, 2010 6:16 AM PDT – – excerpts

    “Even though more than 25 years have passed since I was a Wall Street banker, I follow developments in the financial markets with as much interest as I did when I was immersed in them.

    My Lodi friends know that I still have some associations on the Street. They all want to know what I think will ultimately happen to Goldman Sachs and its high-ranking officials as a result of the recent civil lawsuit brought by the Securities and Exchange Commission that charged the bankers with fraud. The SEC alleges that Goldman created and sold mortgage investments that were secretly intended to fail. Middle America hopes that the worst befalls Goldman. Who can blame them? Few have been left unscathed by Goldman’s sleazy role in the mortgage blowup.

    Without getting into all the complicated details, the deals initially protected Goldman from losses when the mortgage market soured but then ultimately yielded staggeringly high profits for the bank.

    Then, to make Goldman’s public image even worse, when asked about its role in what eventually became a worldwide economic meltdown, Chairman Lloyd Blankfein told the Times of London: “We’re very important. We help companies to grow by helping them to raise capital. Companies that grow create wealth. This, in turn, allows people to have jobs that create more growth and more wealth. It’s a virtuous cycle.”

    Blankfein concluded that he is just a banker “doing God’s work.”

    At the time of his remark, Goldman had posted third-quarter 2009 earnings of $3 billion and planned to pay year-end bonuses in excess of $16 billion. Most observers could not make the connection with a “virtuous” $16 billion and “God’s work.”

    The website lists an impressive total of 21 former Goldman Sachs executives who hold or have held high-ranking positions in the George W. Bush and Barack Obama administrations.

    Some, like former treasury secretaries Robert Rubin and Henry Paulson, are prominent. Others, like undersecretary to the treasury Mark Patterson, are less known but nevertheless hold influential posts.

    Here’s another VIP name you have never heard of: Former Goldman Vice President Adam Storch is the managing executive of the SEC’s enforcement division. That’s right! The same SEC that brought suit against Storch’s former employer, Goldman.

    To those who wonder what might happen to the Goldman thieves, my unhappy answer is, nothing.

    Taibbi wrote that Goldman is responsible for “every major market manipulation since the Great Depression,” and described it as “a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.”

  37. “My task is to ferry wounded souls across the River of Dread until they see the dim light of hope, at which point I stop, push them in the water and tell them to swim.”

  38. When was the last time you posted an update to the “Baseline Scenario”? Not that I don’t like your other commentary, but it was vital to me to have a sane global financial/economic analysis posted regularly during the crisis. I still want it. Can you please continue to do it monthly, or at least quarterly?

    I think it forms a foundation for your value and credibility, and shouldn’t be skipped.

  39. Why Jamie Dimon is Afraid of Elizabeth Warren

    Tuesday, May 4, 2010 – Time/CNN – excerpts

    “This is also the woman that makes Jamie Dimon, the head of the largest bank in America, shake with fear at night. How do I know this? Because I called and asked.

    I tried to set up a debate on the topic between Elizabeth Warren and Jamie Dimon. My pitch was if you feel strongly about the topic just defend it in the pages of TIME magazine, and your side of the argument will be better for it.

    My proposal was that Jamie Dimon and Elizabeth Warren should go on a foreclosure bus tour together. Take a look at the damage that has been done by option ARM loans and 2/28 hybrids and then make the case why the proposed Consumer Financial Protection Agency would or would not have stopped the problems that led to the financial crisis.

    Warren said yes. Dimon said no.”

  40. I forgot to mention, “His Lord Majesty of all Banks”…the “Bank of England”! They own the rater’s. Trust me on this one.

  41. Re: @ Anonymous___Were on a role here. BAC always wanted ML! Make the whole complete (credit cards,motgages,deposits,investment banking,and insurance) doesn’t get any easier.:^)

  42. Re: @ RickK____Goldman is going to the, “Golden Corral for Slaughter” over the ECB,and Greek Tragedy that’s unfolding exponentially as I write. Greece was hoodwinked, and GS’s fingerprints are all over it. PS. I said they should base at $125 – well there’s been a downgrade at earle,florida’s rating agency too junk …I won’t even try to predict where the bottom is! Death by Association!

  43. Goldman Sachs Credit Rating Threatened By Fitch

    MAY 5, 2010 – Huff Post – excerpt

    NEW YORK — “Fitch Ratings said Wednesday that Goldman Sachs’ recent legal troubles and the evolving regulatory landscape might lead the agency to eventually review the bank’s top-tier credit rating.”

  44. Looks like the FIRE economy is burned out.Alas,the paper pushers got all the money and the wrongheaded wretches who make things(Luddites)got the shaft.Ah,who needs a raise?Gimme some more Credit Cards so we can help those Bank balance sheets.

  45. Your question is well worth asking.

    When the American embassy was invaded by Iranians in 1979 and American citizens taken captive, one of the responses by the US government was to order American banks to freeze Iranian deposits held with them whether in America or outside. It was a surgical operation that happened overnight (I recall that it was a Friday, but I haven’t gone back to check. I worked for an American bank at the time in London, responsible for its Middle East relations). Iranian bank accounts were re-named and frozen and transactions over those accounts required US Treasury approval.

    As to your specific questions, I would say that there is such a thing as “economic warfare”. There are many manifestations of that: tariff and non-tariff barriers, transaction taxes, etc.

    I would not venture a quick answer to your question whether dismantling TBTF is equivalent to unilateral disarmament. From my experience, there is such a thing as “economic warfare”. But like real war, the consequences are too horrible to contemplate.

    Which means that, on balance, I believe that the big banks should be broken up.

    I will say this: I believe that TBTF=TB.


  46. Tried reading through the bill last week and actually got a little physically ill…for the reasons you’re highlighting.

    Simply: Obama, Pelosi, Reid, Dodd, Shelby, McConnell, etc.etc.etc…are perpetrating fraud on the U.S. citizenry.

    This is sleight-of-hand, don’t mention the details so you won’t be the wiser but we’re gonna make it all sound so good kind of fraud. (You know, the same kind of fraud as when the president tells us he really really cares about the environment while choosing a Sec of Interior who authorizes safety waivers and oil accident clean up waivers all over the place for BP…then ignores they violated terms of probation for an earlier accident…simply ignores…but hey, look how stringent our laws are! Got it covered…)

    All of it: fraud.

    My take: This isn’t about regulations anymore. Not about derivatives, audits, too big to fail, Glass Steagall.

    What’s coming to a head: The realization that our “leaders”…have lost their Souls. No joke.

    They’ve. Lost. Their. Souls.

    Until that’s addressed: band aids, all of it. Band aids, and intellectual masturbation.

  47. Hopefully some good will come out of the current senate confab, but I would keep an eye on a meeting taking place on May 11th at the IMF in Switzerland
    to discuss the dollar alternatives, the SDR and gold. Think of all going on in Washington at the moment as a place holder. I believe bigger things to come are just around the corner.

    We do not have to pay interest on our money. Eliminate the Fed and go back to US Notes.
    Also, no Au/Ag backing as it is just another version of fiat that bankers can manipulate.

    I trust elected officials more than bankers, especially when it comes to money, simply because can be held accountable.

  49. Between Simon Johnson, James Kwak, Arianna Huffington, Martin Wolf, Paul Krugman, Nicola Gennaioli, Andrei Shleifer, and Robert Vishny, who would you think has read the Basel II regulations and that since they were formally adopted by the G10 in June 2004 governs most of the financial regulations in the world? My guess… no one! They are too busy explaining what happened and what needs to be done!

    But since the 1370 pages of reform currently discussed in Congress do not mention the Basel Committee either… I guess they are all in good company.

  50. The use of the term “economic warfare” is only the term that jumped to mind. To rephrase the question, Are there things that huge banks can do for governments that they might find very useful. If so, letting them get to the point of TBTF might be viewed as just part of the game. If this is the case, then TBTF is simply a permanent fixture on the landscape.

    TBTF=TB is most certainly true — unless you are the President?

  51. I tried. How about a summary of the most interesting points from your perspctive, PK?

  52. You have a website, highlight the important parts and leave the link here. I’m sure many people would love to read it. As far as I can tell all you’ve ever talked about is higher capital requirements for the smaller banks, and I don’t see how that would have done anything but helped, not hurt.

    You may have very valid points. I believe you do have valid points or you wouldn’t keep talking about it. But screaming Basel II all day long and asking the average Joe to read 1300+ pages of mundane reading material probably isn’t going to get you very far.

  53. TBTF banks = TBTF United States?

    A big bank or two goes down, and then the financial system of the US begins to go down. That is, of course, unless “accomodations” are made by China and other countries. A diabolical strategy.

  54. According to Basel II bank loan to a small business or an entrepreneur generates an 8 percent capital requirement but a loan to a triple-A rated client generates only a 1.6 percent capital requirement and a loan to a sovereign rated triple-A generates zero capital requirements.

    That has created large incentives for banks to go the triple-A route and that has created large incentives to follow the opinions of the credit rating agencies too much and those two things together created the market stampede after AAA rated instruments. And since there is a true scarcity of AAA-no-risk lending alternatives, the market, as the market composed of only humans it is, produced trillions of dollars in fake-AAAs the securities backed by the subprime mortgages… and then many followed these AAAs over the cliff.

    The above contains the explanation for the crisis in a nut-shell and if you want to see a version for dummies or bank regulators I invite you to look at

  55. I am not asking average Joe to read 1370 pages of the Financial Regulatory Reform currently discussed in the US Congress. I just say that it is strange that they do not contain a single reference to the Basel Committee or Basel II when on April 28 2004 when the SEC allowed the investment banks to dangerously increase their leverage, it did so by stating that “the consolidated computations of allowable capital and risk allowances [be] prepared in a form that is consistent with the Basel Standards”.

    But I do ask of anyone blabbing out as an expert on this matter, and giving recommendations on the what to do, to be sufficiently knowledgeable of at least the essential elements of Basel II, and I don’t think that is much to ask, on the contrary I think not doing that and still be blabbing is an insult to the readers… it is like a preacher that has never taken the time to read the Bible himself.

    And by the way I have never talked about smaller capital requirements for the smaller banks. I have said that bank lending to a small business or an entrepreneur should not generate larger capital requirements than bank lending to something AAA rated and that by being AAA rated anyhow has easier access to funds. Doing so has introduced a regulatory bias against risk that has completely distorted the markets.

  56. Alan: I offer only this idea, gleaned from wide reading and limited observation.

    A government, when dealing with a certain sector of the economy, has only two choices: laissez-faire (excepting consumer protection) or totalitarian regulation. Half-measures will not work. Companies endowed with special powers by government decree and then allowed to behave as free-enterprise corporations, quasi-private companies, GSE’s, and suchlike cannot be successfully regulated. Sooner or later they will be gamed into failure by free actors exploiting government guarantees.

    As a general rule, where the possibility of mono- or oligopoly exists, comprehensive regulation must be enforced by the creation of a public utility or by nationalization. Nothing less will suffice. Where free-market forces function efficiently, as in the production and sale of consumer goods and services, heavy-handed government intervention is not needed.

    As for the banking system today, it has been allowed to grow into that worst possible monster, a giant capitalistic-socialistic hybrid; fattened by government protection, dancing around whichever ad hoc regulation might get in its way. And simply because government failed for years to recognize that it had two–and only two–choices in the matter: cut the banks loose or bind them up tight.

    The government forfeited those choices. Today, banks have become so large and powerful, it is doubtful they can be made to submit to onerous regulation. And equally doubtful that they will abandon the government safeguards that boost their profits. The game, alas, has probably been lost.

  57. I think that’s quite a fair and reasonable answer, those 2 comments you just made above are the best comments I have ever seen from you, and If I was you I would save both of them and repeat them (“copy and paste” if you will) everytime you think that perspective or viewpoint is missing. I think it’s vastly more useful and insightful than going after Mr. Kwak and Mr. Salmon.

    That is meant as a compliment. Not a criticism or insult.

  58. Great post, James. Your conclusion is spot on: “Given that whatever comes out of Congress will be imperfect in anyone’s eyes, whether the Obama administration agrees will be of crucial importance.”

    There won’t be a do-over on this. Either we get good legislation or we’re sandbagging ahead of the next toxic-waste deluge that surely will hit global economies and markets absent meaningful reform. TBTF is the much harder issue. Any equivocation on this will demonstrate two things: 1) the equivocator(s) will have revealed themselves to be in the employ of the TBTF firms; 2) oligarchy will have replaced capitalism in the West, particularly in the U.S. China’s trying to evolve out of state-sponsored oligarchy; Russia demonstrates its all-too-certain end.

    The stakes couldn’t be higher.

  59. Kerowski,
    I didn’t remember you breaking down the exact percentages (1.6 and 8) on the capital requirements but I probably missed it. I would stress the exact numbers if I was you or it just seems like so much haze. I agree with your argument here very much.

    I think it gets back to asset quality and not just to capital requirements. There has been too much emphasis (in conversation and regulations) on capital levels and not enough stress put on asset quality. I discussed this in a post on my blog largely borrowing from a paper put out by the St. Louis Federal Reserve. I would be flattered if you read it and gave me your thoughts Kurowski.

  60. Mr Trouserman, you write:
    “A government, when dealing with a certain sector of the economy, has only two choices: laissez-faire (excepting consumer protection) or totalitarian regulation. Half-measures will not work. Companies endowed with special powers by government decree and then allowed to behave as free-enterprise corporations, quasi-private companies, GSE’s, and suchlike cannot be successfully regulated.”

    My response: there are lots of industries which have
    lots of autonomy, but are quite severely regulated.
    Examples: The pharmaceutical industry; we have
    great confidence that we can buy any bottle labeled
    “aspirin” and we’ll get the same chemical, with the
    same weight, that e.g. Bayer offers. The car
    industry is another; there gotta be seat belts, and
    one had better not be caught winding back the

    I would further claim that the financial industry
    is _simpler_ than the pharmaceutical industry or
    the auto industry, or could be made so. And that’s
    what I want to discuss here!

    You write in your final paragraph: “The government forfeited those choices. Today, banks have become so large and powerful, it is doubtful they can be made to submit to onerous regulation. And equally doubtful that they will abandon the government safeguards that boost their profits. The game, alas, has probably been lost.”

    Very likely true, in the short run. But I, like our
    gracious co-host Mr Kwak, wish to discuss the long
    SYSTEM LOOK LIKE? This is a difficult question, but
    not IMHO too difficult for the giant brains on this
    blog. And once we arrive at some answers, we;ll be
    better equipped to continue the ideological struggle
    with the Rich and Powerful.

    Best wishes,

    Alan McConnell, in Silver Spring MD

  61. That’s my point. 75% (or higher) of americans still think we were “doing what was necessary to save Banks.” The rest of us 25% now understand the kind of betting and fraud that was going on, and we’re yelling how these aren’t banks, but nobody is listening anymore. Nobody cares. The ship has sailed. I mean, no offense to BaselineScenario, but this isn’t exactly a mainstream blog with a huge readerbase.

  62. Could be. My point in raising this question is whether the kinds of things Kwak and Johnson are raising on this blog, as much as I agree with them, do not touch some very central issues and therefore cannot happen.

  63. Our partner in crime, repos, and what not. The UK is our off balance sheet affiliate. BAC/ML, absolutely right until Ken got scared of the price. Then Paulson threatened him. You see that clip? Very interesting.

  64. Let me explain it this way… over the last years the banks have been allowed, by Basel II, to lend money to Greece with a capital requirement of only 1.6 percent, which results in an authorized leverage on sovereign Greek debt of 62.5 to 1. I would think that had something to do with this public debt bomb exploding in our faces… wouldn’t you?

  65. Re: @ Anonymous____Yes,…but Ken wanted ML for alot less ,and new he/they (BAC) could get by wading (honed predatorial instincts) through the crises. Hank was well abreast/aware of the rapid unraveling of the financial markets ,and the deal had too happen. Thus he (Hank) throws BAC a huge Multi-Billion$$$ (gift?) bonus too facilitate the deal. Bingo! Just last month BAC made good on all TARP debt. Amazing,…simply amazing!

  66. RE: @ markets.aurelius____The “TBTF” is an empty “Self Proclaiming Prophesy” that has run out (ink or paper) of “Pulp Fiction Papyrus”,unless…and that’s debatable if ,and only if, the (the Fed printing more debt,when the financial abyss is full) wadies are flooded with (suckers bet)hope,that springs eternal, only to produce more (government-what me worried?) disillusionment?

  67. Why should Dimon spend time touring or debating with Ms. Warren when he can be spending that time dishing out his ample largess to those willing hands/bank accounts in DC, better known as our Congress?! Our country is run by the lobbies, not the debaters.

  68. The Europeans, accepting the dictates of the Basel Committee, allowed their banks a 62.5 to one leverage when stocking up on Greek debts and alike… if that is just not plain dumb and stupid what is?

  69. >At the margin, every little innovation that makes markets more liquid does provide a small benefit to the economy in the form of better capital allocation;

    But the system as a whole, left to its own devices, seems to massively misallocate resources (human, capital, technological). It seems to be an emergent property of the system.

    Heresy: the invisible hand massively misallocates resources.

  70. Our democracy and our “financial system” were in fact built upon strength through decentralization with a big-brother over watching us. The smaller states or in this case financial institutions could strive to do whats best for their local constituents in the context of larger big-brother laws. The big-brother would make sure your adolescence doesn’t hurt the family by lending you cash in a crises and slapping you in the face when you violate family policies. Glass-Stegal and the current reform could be a part of this but it may be an issue that is generational (sorry, boomers) due to the fact that neo-classical economics is taught as true doctrine in most schools. A frustrating experience for pseudo-intellectuals wondering what WE are going to have deal with when you all retire. The tools, technology, and educattion required to fix this needs to be looked at. This was an empire built over many years and is deeply ingrained. I am barely educated and probably misinformed. Input welcome.

Comments are closed.