Wednesday, January 27, 2010
The administration might be settling for superficial progress on financial reform to avoid being on the wrong side of public anger; a better approach would channel the anger into making meaningful reform.
President Obama was flanked by his top economic advisers when he outlined a vision for financial reform Thursday morning. The economics team is filled with professionals of the first order, including Christina Romer, chairman of the Council of Economic Advisers, Lawrence Summers, director of the National Economic Council, and Paul Volcker, the former Federal Reserve chairman. The elite company bodes well for the continued operation of the White House because, as F. Scott Fitzgerald famously wrote, "the test of a first-rate intelligence is the ability to hold two opposing ideas in the mind at the same time, and still retain the ability to function." The bad news is that the economists in positions of power will be sorely tested because recent banking initiatives and efforts toward financial reform are fundamentally inconsistent.
This lack of coherence signals either a worrisome misunderstanding of the nature of the financial crisis or a willful attempt to play to the pitchfork-wielding crowd crying out that somebody, somewhere must pay for market misdeeds. Untangling the mess requires first documenting the evident inconsistency in policy pronouncements and then speculating as to the underlying motives.
The president signaled his intention to put new protections around the federal safety net. Under the plan, banks with insured deposits would not be able to run hedge funds or private equity firms or to conduct proprietary trading. In addition, the government would not let financial institutions get too large, as measured by their share of total bank assets.
The lack of coherence of recent efforts toward financial reform signals either a worrisome misunderstanding of the nature of the financial crisis or a willful attempt to play to the pitchfork-wielding crowd.
Unfortunately, these special protections are misdirected. The key actors of the 2007–2009 financial drama never took insured deposits, including Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, and American International Group. As for banks, they lost money the old-fashioned way of bad real-estate lending and the newfangled way of underwriting complicated mortgage-backed securities. In the act of underwriting, they retained the worst bits and pieces of the mortgage-related securities, which promptly cratered when the underlying home values soured. Neither risk magnet was mentioned by the president. Moreover, insured banks are already protected by firebreaks dug by Section 23 of the Federal Reserve Act. Essentially, the rules prevent the management of a holding company from raiding the capital of an insured bank so as to benefit uninsured affiliates.
Perhaps legislative language will clear up these issues. But financial reform is not an area where executive improvisation pays off. The president has called jump ball on the future structure of our financial giants. He has also already laid out a plan to claw back federal Troubled Asset Relief Program outlays by taxing financial institutions. Uncertainty about future legal structure and certitude about future taxation can only further dampen banks' willingness to lend. Herein is the administration's key inconsistency: Bankers are exhorted to support job creation at the same time that being a banker is made harder.
Adding new rules and taxes, as the administration proposes, only encourages firms to ramp up their innovation in eluding the restraints.
Of course, it is difficult to sympathize with financial executives who survived a near-death experience only to return promptly to their old ways of paying themselves bloated bonuses. The fat profits of banks, however, signal the underlying rot in the industry, not that they have returned to health.
Over the past few decades, our government has let financial institutions get increasingly more complicated. They customized securities to take advantage of every possible regulatory and tax advantage. In the process, they splintered their balance sheets to get a seal of approval from their fellow travelers, the rating agencies. The result was increased opaqueness of financial accounts that made effective supervision impossible, blunted market discipline, and rendered the firms unwieldy to manage.
Adding new rules and taxes, as the administration proposes, only encourages those firms to ramp up their innovation in eluding the restraints. Balance sheets will get more complicated, financial firms will become more intricate and fragile structures, and more activities will migrate outside the supervised world. It will look on the surface like the safety net is more secure because insured banks will be involved in fewer risky activities. But as shown over the past two years, when push comes to shove, the government will bail out the uninsured as well as the insured at a time of significant market strains.
Herein is the administration's key inconsistency: Bankers are exhorted to support job creation at the same time that being a banker is made harder.
The public is angry at the patent unfairness of the financial system. Regrettably, some of the anger is justified because providing bailouts to the largest firms has fostered the impression that being bigger is better. The administration might be settling for superficial progress at this juncture to avoid being on the wrong side of this sentiment.
A better approach would channel this anger to make meaningful progress on financial reform. Consolidate federal supervisory agencies so that the government limits opportunities for regulatory arbitrage. Enforce strict consolidation of bank balance sheets and require different activities within a holding company to be chartered and capitalized separately. And require more capital to serve as the ultimate protection to the safety net.
Banks are not going to be an engine of expansion in the near term. They have to dislodge legacy assets from their balance sheets and recapitalize. Real progress would be made if the direction they were headed was to make the system simpler and safer in the long run. In the interim, other sources of stimulus have to be brought to the fore. Arguing otherwise is just keeping two inconsistent thoughts in mind at the same time. The quote from that famously depressive Fitzgerald, by the way, comes from a collection titled, "The Crack-up." Let it not describe economic policy making.
Vincent Reinhart is a resident scholar at the American Enterprise Institute.
FURTHER READING: Reinhart further explains finance policy within “The Peril of Anointing a Favored Financial Few,” “The Perfect Financial Storm Fallacy,” and “The High Cost of Getting the Story Wrong.” He also details “Simple Rules for Complex Financial World” and pros and cons of “The Nationalization Paradox” for banks. Before the Federal Reserve Bank of Philadelphia, he made “The Case for Simpler Financial Regulation.” Earlier, he succinctly explains “The Right Role for the Fed.”
Image by Darren Wamboldt/Bergman Group.