The Ripon Forum

Volume 44, No. 1

Winter 2010 Issue

Financial Reform: Getting it Right

By on October 23, 2014

Financial reform begins with good policy, not populism

More than a year after the financial system nearly collapsed, the administration’s lurch into populist rhetoric has put the already-stalled effort for regulatory reform into reverse gear.

In tacking hard left, President Obama has shifted focus from ensuring that the financial system contributes to growth and job creation through intermediation (e.g. lending) to instead bluntly constraining the size and scope of bank activities. Protestations by White House aides that proposals to punish banks were long under consideration, if anything, make the situation worse. It is sadly revealing to learn that the President’s jarring switch to non-substantive rhetoric is actually the result of a considered policy process rather than a crude but understandable political calculus.

Two policy switches in January 2010 are directly at odds with President Obama’s putative agenda on financial reform. First, the proposed tax on banks is at odds with the earlier urging of bank executives (those who would show up) to increase lending, since the tax is meant to be levied on funding that banks would use to support increased lending.

The second lurch on financial regulatory reform, immediately following the Massachusetts election, involved a salvo against proprietary trading and toward limiting the size of U.S. banks. This appears to be a strike against a phantom menace, since the administration put forth no evidence that either trading or size were meaningful factors behind the crisis or pose a risk to the economy or to public resources going forward. After all, some of the largest financial institutions were islands of relative stability during the crisis (even as others were not) while dozens of smaller banks have failed. It might sound good to attack banks, but it’s not necessarily the right move for the economy and for the millions of American families with low and moderate incomes who benefit from expanded access to credit as the result of financial innovation and the activities of large banks.

It might sound good to attack banks, but it’s not necessarily the right move for the economy…

The strike against proprietary trading is perplexing, since it would be well-nigh impossible to distinguish this from banks’ normal activities in making a market for clients looking to buy and sell securities such as stocks and bonds. A bank acting as a “broker-dealer” will at times accept a sell order from a client that results in taking a security or derivatives position onto its own book for a while until it finds a buyer or an offsetting derivative position. This risk-taking helps create the deep and liquid financial markets that attract capital to the United States — and that not incidentally help fund the massive federal borrowing in the “new era of fiscal responsibility” proclaimed in President Obama’s February 2009 Budget.

The impression is that both lurches on financial reform are driven by political necessity. When President Obama is quoted in the press as being upset that he is on the “wrong” side of an issue, it should be understood that he means the wrong side of popular opinion, not the wrong side of substance. As with his flailing efforts to challenge the AIG bonuses condoned by his top staff, the President is following the pitchforks rather than seeking to channel popular energies into productive legislative efforts.

All of this is unfortunate because it detracts from the still vital agendas for regulatory reform that would help prevent future crises and provide a framework under which the government could better deal with financial crises when they inevitably arise.

The key aspects of the positive agenda on financial regulatory reform focus on helping to detect activities that contribute to systemic risk, and improvements to the way that failing financial firms are dealt with. These policy areas are related; reforms that make clear to banks that they will be allowed to fail in the end will lead to changes in behavior by market participants that help make failure less likely.

While the financial industry is among most regulated in the U.S. economy, the crisis exposed gaps in oversight and information gathering that would be useful to fill. The Federal Reserve has become politically unpopular, but it remains the only government institution that has both the broad overview of the economy and the deep knowledge of the financial system needed to serve as an effective backstop to other financial regulators. Other regulatory agencies necessarily have a narrower view — the FDIC, for example, focuses on the status of its deposit insurance fund to the neglect of broader systemic issues.

While the financial industry is among most regulated in the U.S. economy, the crisis exposed gaps in oversight and information gathering that would be useful to fill.

It might be useful to establish a council of regulators to watch for systemic risk, as now proposed by House Financial Services Committee chairman Barney Frank, so long as the Fed remains the ultimate ‘free safety’ in football terms, with the mandate to run down financial sector activities that appear to put the system at risk or that seem to be motivated mainly by the prospect of a government guarantee or backstop. Such a mandate would have led to a prolonged whistle-blowing at Fannie Mae and Freddie Mac, the two government-sponsored enterprises for housing finances, whose outsized portfolios put the banking system at risk and necessitated a costly taxpayer rescue of these firms in September 2008.

Even with this change, it is inevitable that the financial industry will eventually develop problems that include the potential collapse of major industry participants. Resolution authority over non-bank institutions would provide a roadmap for the government to deal with firms that are not banks (such as the holding companies that own banks along with other financial subsidiaries such as insurers and broker-dealers) or the forty or fifty banks that are too large for the effective capabilities of the FDIC. The administration’s approach would institute a system under which the executive branch could take over a failing financial firm and use taxpayer money to support it. Ironically, this proposal — now lost in the vapors of the President’s populist rhetoric against bailouts — has the essential characteristics of the TARP in allowing the executive branch to put public money into a private firm without a vote of Congress. And it goes a step further, by allowing the government as well to change contracts. Put simply, the administration’s proposal is for a permanent and supercharged TARP.

A better alternative would be to improve the bankruptcy process, to ensure that troubled firms are allowed to fail without putting at risk the rest of the financial sector or the broader economy. The failure of Lehman Brothers had impacts on the broader economy through lax oversight of money market mutual funds that held Lehman’s debt, through a disorderly unwinding of Lehman’s derivatives positions, and through poor coordination between the U.S. and UK bankruptcy regimes that left the assets of some Lehman clients “frozen” in London. These failings can be addressed—and doing so would be preferable to a permanent TARP. This is not saying “no more bailouts ever,” but it does require a vote of Congress for public funds to be deployed at length in the future.

Such a focus on bankruptcy would help fix market expectations that firms would be allowed to fail. This would affect risk-taking behavior and thus help reduce the likelihood of future crises.

Phillip Swagel is a visiting professor at the McDonough School of Business at Georgetown University. He previously served as Assistant Secretary for Economic Policy at the Treasury Department.

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