Geithner’s Other Plan: Regulation
My he’s a busy lad.
Tim Geithner spent some time today presenting in a broad way – does he ever get into details? – the shape of a new regulatory structure for finance in the US. The New York Times has the reaction here: Plan for Financial Oversight Draws a Mixed Response
OK. It is hardly surprising that the areas of finance that are currently either not regulated at all, or are lightly regulated, would be a touch skeptical. There is no news there. So the NYT reporter asking a bunch of private equity types whether they want to be checked by the Treasury Department id not going to elicit whoops of joy. The reaction is, however, a sign of the amount of lobbying that will inevitably go on between now and the day legislation is signed into law. Because of American legislative process new laws and regulations are hard to predict, and we can be certain that whatever the administration fires off as it opening salvo is not what appears on the books.
So setting aside initial industry reactions and even the administration’s own plans, whta should we look for?
First: It is clear we need to set limits on any financial organization so that it cannot become ‘too big to fail’. The combined assets of our largest four banks [Citi; Wells Fargo; JP Morgan Chase; and Bank of America] represent almost two thirds of all banks assets in the country and a huge chunk of GDP. We simply cannot have one of them fall into bankruptcy. They will always be able to avoid the full consequences of poor management as a result. It is central to well functioning economies that firms go bust if they are poorly managed. That prevents assets being constantly badly used: there is pressure from other managements at other companies to use those assets more efficiently. However a bank that knows it will never be allowed to go under will inevitably adopt poor policies and eventually will flirt with danger since there is no market mechanism to apply pressure to its management. This is what has happened in many cases in this crisis. The trade in derivatives was bizarre and largely without a business rationale except for quick profits. True market pressure through the threat of bankruptcy should and probably would have forced managers to pay more attention to what risks their traders were taking.
Second: The US has no way to take a large multi-business financial holding company into receivership. This has to change. The entire AIG fiasco flowed from the fact that at the crucial moment the no government agency had the authority to force AIG to break itself up; to renege on contracts; or to force creditors to accept less than 100% payments. The political backlash stemming from AIG is entirely due to this lack of legal authority. Right now the only area of finance where the government can step in and force resolution is in banking [as an example the FDIC just last week forced a Colorado bank to close; sold its branches and some assets to a Texas bank; and absorbed the losses that had driven the Colorado bank into insolvency]. This is exactly what the Fed wanted to do with AIG last fall, but they had no ability to do so. Instead we were stuck with a Rube Goldberg fudge.
Third: The whole ‘shadow’ banking system needs to be brought under regulatory scrutiny. There are huge financial firms, such as Countrywide Mortgage before its demise, GMAC, and GE Capital that are entirely unregulated, or are not regulated according to bank rules. Yet they have immense impact on the financial system. AIG itself is an insurance company and there is no Federal level regulation of insurance companies – they all fall under state regulators. Further: regulation should be pushed into the private equity and hedge fund domains. Neither of these groups are ‘implicated’ in the direct implosion of the financial system, but they handle vast sums of money and are intimately involved in many of the derivative product markets at the epicenter of our crisis.
Fourth: International cooperation must be tightened up. This is not a domestic US issue. AIG’s booked its credit default swap business our of its London office through a French based banking subsidiary to avoid US oversight and to move cash through different tax domains. One of the biggest stumbling blocks facing the Fed as it tries to undo AIG is exactly that it has no direct authority over foreign operations. As it pumped cash into AIG to stem bankruptcy, AIG’s foreign operations were beyond the Fed’s ability to support. In particular getting cash to the London office through the French bank slowed the bailout to a crawl more than once.
Fifth: The Depression era laws that separated investment banking from commercial banking need to be re-instituted so as to lower the risk within the Main Street banks. Investment banking includes all the riskier activities and can often, as we have just seen, cause wild swings in profits. Main Street banks should be prevented from getting into those activities and forced to concentrate on serving depositors and small to medium sized businesses.
Sixth: Capital adequacy and risk management rules need to be updated to take into account the interconnectedness of banking. One of the problems we have just experienced is that each bank was looked at in isolation and not as part of a wider system. That meant that levels of capital were accepted and risk methods were deployed ignoring the ‘knock on’ effects of the potential failure of other banks. This has cropped up as the dreaded ‘counter-party’ argument. We couldn’t allow AIG to default because that would cause its counter-parties to lose too much and would have forced them into bankruptcy too. This interconnectedness needs to be adjusted for in banking rules and regulations.
Much of this is in Geithner’s list so overall I think he’s on the right track. The administration needs to use this crisis and the current public outcry against the banks as an opportunity to push through a thorough reform of financial system regulation. I would like to see one uber-regulatory agency to replace the regulatory functions of the Fed, Treasury, FDIC etc. But I won’t hold my breath on that one.
So I give Geithner good marks on this effort.
His other plan, the one for buying up toxic assets … not so good. That I will write about again over the weekend.
