Finance Reform

Well things are heating up. Senator Dodd released his much awaited – by people like me that is – proposed legislation for the reform of our broken down financial regulatory structure. The legislation weighs in at 1,136 pages of text, so I doubt whether anyone has read it yet unless they received a copy ahead of time. I certainly won’t be wading through it all. I will use the executive summary as my source for the major proposals.

Here are the highlights, or ‘lowlights’ if you’re at the Federal Reserve Board:

1. Dodd proposes to establish a single large new regulatory agency[the Financial Institutions Regulatory Administration or ‘FIRA’], similar to the FSA in the UK, that will take over many if not all the regulatory powers now vested in the warren of agencies in Washington. The idea behind this centralization is to prevent banks from getting themselves regulated by the most lenient overseer. This ability to shift the regulator with oversight over your bank – an ability known as ‘regulatory arbitrage’ – undermines the current system and allows banks to cherry pick the regulations they want to be governed by. Ending this ability is key to future enforcement. I have doubts whether Dodd will get his way with this proposal, the current agencies all have cheering sections in Congress and the massive inertia within the American system will most likely kill the initiative off. Plus centralization in the US is simply a first step: international regulation needs to be tightly synchronized as well is we are to eliminate global regulatory arbitrage.
2. Once FIRA is set up the current Offices of Thrift Supervision and Comptroller of the Currency would both be abolished and their functions absorbed into FIRA. Likewise the bank regulatory aspects of the FDIC would be rolled into FIRA as would those of the Federal Reserve Board.
3. The proposal also gives the SEC an ability to fund itself by keeping the fees it levies on the financial industry.
4. A controversial aspect of the Dood reform is that it establishes a Consumer Financial Protection Agency [‘CFPA’], which is designed to monitor and control the products that banks create and sell to consumers. This is obviously a reaction to the sub-prime mess when lenders ran amok with fancy, and often incomprehensible, loan types, and then sold them to people who were not credit worthy if the fine print in the loan ever kicked in. Naturally the fine print always kicked in and precipitated the mass of delinquencies and foreclosures we are now cleaning up. I like this idea. The so-called innovation in banking is not innovative at all. It is simply an endless permutation of the same old products wrapped in ever more obtuse legal language. Innovation is supposed to drive higher value to the customer, but most bank ‘innovation’ is designed simply to open new sources of fee income for the banks. This proposal is vehemently opposed by the Republicans – they object to anything that seems to limit the good deeds of the market place – and the various bank lobby groups are pouring money into a fight to stop its successful passage. Given that both the House bill and the Obama administration endorse a similar concept, the odds are that we will get some form of CFPA. Good.
5. Dodd also proposes setting up a new agency to govern financial stability. This agency is the lynchpin of the new Dodd style system of limiting the damage ‘too-big-to-fail’ banks can do to us all. The idea behind this agency is that it would monitor and manage the systemically important organizations – think Citicorp or Goldman Sachs – and suggest rules and limits on their activities to prevent their gambling taking us all down the way they did in 2008. The need for such an authority is an open acknowledgement of the total failure of the current system to account for the risk embodied in all the interconnections between the biggest banks. Remember it was our complete failure to understand systemic risk that led us to have to bail out AIG and bail out pay off Goldman Sachs et al through the back door by honoring those counter-party positions they had all foolishly entered into. The overall notion in this initiative is to limit the extent of the socialization of losses needed in future – Dodd’s fine print even has this agency given the power to recommend breaking up banks that are deemed too large for the safe operation of the entire system. Also good.
6. The proposal also includes a raft of measures designed to discourage banks from becoming to big. In this respect Dodd’s legislation fits right in with all the other proposals floating about. This is also a welcome change, although I remain skeptical about its impact: we have capital regulations now. The question is getting them enforced.
7. Small banks would find themselves subject to federal regulation if Dodd gets his way. This will annoy all those country bankers who have a cozy relationship with their local state regulator. It is about time we abolished the state level regulatory structure – not only does in encourage regulatory arbitrage, it helps maintain a fragmented industry. The proliferation of small banks prevents the emergence of new medium and larger banks that could compete with, and therefore limit the growth of, the existing mega banks. If we believe in a market system then we need to ensure that system is full of competitors and is not dominated – as it now is – by an oligopoly who can impose rents on the rest of us. {Rent seeking is the word economists use to describe activities where one person or organization can extort wealth from others by employing legal, but non-competitive, methods. Enforcing a patent is an example. Lobbying and getting preferential legislation is another}. One way to limit the damage of the pervasive rent seeking now current in finance is to encourage the emergence of healthy and innovative competitors. Getting all our small banks onto one regulatory playing field would be a step in this direction because it would probably encourage consolidation across state lines, where asnow the various State regulators discourage such activity.
8. The last big change Dodd proposes is to bring all hedge funds under a strict regulatory framework. They would be required to register with the SEC. Further: hedge funds and private equity firms would be subject to capital requirements for the first time and may even be broken up if deemed systemically too large. This is a major step towards bringing the so-called ‘shadow banking system’ into the daylight and set up under the same controls as the normal system. This is a very good move.

That’s about it.

Predictably the Fed and the FDIC have already mounted the barricades in defense of their entrenched positions. The Fed’s big criticism of the Dodd proposal is that it strips away their ability to use their regulatory control of big banks as a way to take the pulse of the economy – they regard this ‘touchpoint’ as an important source of information as they manage the money supply. They also reject the measures the proposal includes to open up their activities to wider scrutiny – by making appointments more subject to public input for instance. They are wheeling out the dreaded ‘the Fed must be politically independent’ defense tactic, which is sure to energize the financial market and right wing analysts to become allies of the Fed.

I agree the Fed should be independent of direct political control. Its Board should have a mandate unfettered by political agendas. But, just as important, the Board should not be dominated by the banking industry – the Chairman of the New York Fed is an ex-Goldman executive who was trading his Goldman stock at the same time as sitting in on meetings to determine who should, or should not, be bailed out. It is this clear conflict of interest that Dodd is taking aim at, not political independence.

In any case the recent record of the Fed just doesn’t stand up: they are so embedded with Wall Street that they are incapable of executing a regulatory mandate effectively. They have swallowed the same free market ideology that misled the banks and even now don’t seem willing to admit much by way of error during that 2002-2007 period when the current bubble was being inflated largely as a result of Fed policy and inept oversight.

I will end with this latter point: defenders of the Fed loudly proclaim its need for independence. But in a broader sense the Fed, under Greenspan in particular, was anything but apolitical: it was a vehement advocate of the same theory and ideology that was the foundation of Reagan/Bush style Republicanism. Greenspan, more than once, intervened to prevent regulation of things like derivatives, and openly supported the modern Republican view that government is a problem and not a source of solutions. While I admit the entire political world has been infected with this worldview – Rubin and Summers in the Clinton years were just as culpable – the Fed under Greenspan became more than usually tainted by a particular political point of view.

So the question becomes: can the Fed ever be ‘independent’? Or is the search for independence simply a cover for its adoption of free market ideology?

This is not academic.

The big discussion at the Fed currently is when and whether to raise interest rates. Those that want higher rates advocate a raise because they want to defend price stability – they are afraid of inflation – which is one of the Fed’s two legal mandates. They are by and large are the free market folks. Those that push back are driven by the other mandate the Fed has: to support employment. During recent years the first of these two mandates, the fight against inflation, has dominated the other. This is a political choice that favors business and banks over workers. It gets interesting this year if unemployment keeps rising even while the economy starts to grow. The pressure to raise rates will increase as GDP ticks up. But such a move would damage the prospects for a fall in unemployment. Left wing politicians will want lower unemployment. Right wing politicians will want to limit inflation.

Whichever course the Fed chooses is thus political.

So just how independent can the Fed truthfully be?

Not so much.

Which is why opponents of opening up the Fed with a more transparent management style need to find a better defense than its purported independence.

Meanwhile … back at the regulatory ranch.

The Dodd legislation conforms fairly well with the House and administration proposals. I hear the the administration is even willing to support the establishment of FIRA, which they initially opposed.

Given the total opposition coming from the Republicans, I don’t see to much time being invested in a fruitless search for ‘bipartisan’ support for reform. Having been burned in the health care pseudo- debate, where bipartisanship was mocked by the actual discussions, I hope the administration and the Democratic leadership plunge onward without distraction.

This is not to say I wouldn’t support debate. Clearly on something this important we need healthy discussion. But I emphasize that word ‘healthy’. Name calling and obduracy are not healthy and don’t constitute debate. They are merely obstructionism and should be ignored.

Given the recent crisis and the evident failure of our laissez-faire system, we need to re-regulate finance. With the Dodd proposal now on the table the process has begun in earnest. I would like the Republicans to play a constructive role in getting the nation’s banking system safe again. If they join in the debate, then good. If not, well that’s just fine.

Either way we will get reform.

Good.