Bank Reform Monday

Well, here we are. The Senate is heading for a showdown today on bank reform. The odds are that the Republicans will vote against allowing a vote. That will trigger a pile of useless invective from both sides. Then, miraculously, a brokered solution will pop up and be allowed to the floor. Quite what that compromise will contain is anybody’s guess right now. Oh, and along the way the GOP is likely to introduce its own reform bill, one that has none of the nastier anti-Wall Street components and definitely doesn’t have any consumer protection in it.

So.

Are we there yet?

Not really.

The bigger issues remain to be solved.

One piece of good news is that the Democrats managed to coalesce around a decent regulatory framework for derivatives trading. Their proposal is based on the bill agreed to in the Agriculture committee last week. For those of you who are confused as to why the Agriculture committee plays such a prominent role in financial reform I should explain: derivatives used to be useful, many still are, and are used frequently by farmers to lock in the value of the crops they are producing in advance of harvest. Most agricultural products are bought and sold on futures markets, and options trading is very common in those markets. It is no accident that the center of gravity for exotic derivatives trading was Chicago, or that the Federal Reserve Board system has an excess of Midwest representation – there are more Federal Reserve Board districts in the Midwest than there are out west or in the south. It is a throw back to the agricultural era of American history that farming has an oversized say in American finance and politics, completely out of proportion to its contribution to GDP. One legacy of this antique past is that the Agriculture committees in Congress have oversight of, or at least a major say in, matters concerning derivatives.

Back to today.

The most likely outcome of today’s posturing will be a decision to vote later in the week on a hybrid bill. Unfortunately this hybrid is not going to solve our problems. I doubt whether it will include sufficient restrictions on the banks in terms of size or activities. Instead it will touch all the sensitive points lightly in order to look comprehensive. The big problem seems to be that Senator Dodd has yet to embrace the fact that Wall Street in its current guise is not performing its socially acceptable function – he appears to have become enamored of Wall Street’s self-image rather than its empirical impact.

Still the Dodd proposal is better than nothing and gives us a slight step up from the mayhem of the Reagan/Clinton/Bush deregulatory frenzy that allowed the banks to blow the economy up so easily.

Let me reprise the key features I see as essential to reform, but currently lacking in the most likely legislation:

1. We need tough limits on bank size. This means breaking up the three or four largest banks, and setting such onerous penalties on them that they never cross the size boundary again.
2. We need to break up functions in the style of the old Glass-Steagall Act. If bankers want to gamble they should do it with their own money and not ours. I am a big proponent of private banks where the partners are actual partners with their own net worth at risk.
3. We need to eliminate via prohibition, any ‘synthetic’ derivatives. In order to fulfill their social purpose derivatives should be based on underlying assets, not on bundles of other derivatives.
4. We need to eliminate the rating agencies in their current form – they were pernicious co-conspirators enabling the disaster. 93% of all AAA rated sub-prime based mortgage backed securities rated in 2006 have gone belly up. That is an extraordinary record of failure, and one that totally discredits the rating industry. Shut them down.
5. We need to conform our legislation with international efforts to eliminate cross border regulatory arbitrage and to make the winding up of bankrupt banks both more speedy and less contentious.

For the record: I don’t see higher capital levels as a complete answer: many of the banks that ended up in trouble had decent capital ratios and their problems stemmed from liquidity, market, and management failures just as much as from a capital shortfall.

We should also all be clear: the outcome of good reform should be a larger number of banks, competing across reduced lines of business, and a return to the old divide between commercial and investment banking. The process will inevitably be messy, and no one ‘solution’ will deal with the systemic problems. To be effective reform has to be blunt, brutal, and straightforward. Trying to nuance and use clever wording to deal with the banks plays into their hands: they are extraordinarily good bureaucrats who know how to split hairs better than any other businesses. To combat them we need simple declarative statements and a very heavy hand.

Finally, as we await the events of this afternoon and evening, I should add that I am not concerned at all about Goldman Sachs profiting by betting against the mortgage market back in 2006 – 2009. The media has this one wrong. Short sales and other tricks designed to profit from a collapsing market are valuable tools in making markets work properly. Notice I didn’t say ‘work efficiently’ since I do not believe in efficient markets! Having said that: Goldman has every right to bet against the bubble. If they profit then so be it. The bubble itself was the problem, not the folks who profited from its implosion. My anti-Goldman rants are focused on its duplicity with respect to its clients. I find it abhorrent that they did not disclose their positions, and that they bet against products that they created and sold. Their problem is that they are now so large that if they want to be clever and bet against bubbles etc they will inevitably be betting against positions they themselves created. They are so large that they will keep on tripping over themselves. This size forces them into the kind of duplicity that I find deeply unethical. A defense based upon ‘clever customers know we are crooks’ is hardly one to be proud of. All of this gets eliminated when Goldman is broken into several parts and those parts then compete and bet against each other.

Meanwhile, keep an eye on the Senate. Bank reform is essential to our economic health. Let’s hope the new law isn’t too big of a fudge.

Or is that hoping for too much?