Senator Dodd

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Bank Reform: Contingency Planning

A couple of days ago I gave the thumbs down to the Dodd bank reform proposal, but in the past couple of days it has become clear I wasn’t sufficiently open about why.

One reason: bank behavior is not our only problem. Bank size is too.

Maybe one way to get at why this is so important is simply yo return to aspects of the crisis. There was no explicit taxpayer guarantee of AIG, but we bailed it out anyway. We allowed Bear Stearns to be pushed into a merger, yet we allowed Lehman to go out of business altogether. In short there was muddle and confusion everywhere, with ad hoc decisions being the order of the day rather than the execution of a well known and well rehearsed rescues plan.

Plus, and this is where I am most adamant, the crisis revealed the extraordinary size of the contingent liability the government has.

I find it odd, no positively annoying, that people who decry the use of off balance sheet accounting by the banks would then condone off balance sheet accounting by the government. Yet that is exactly what our continued guarantee of the banks amounts to. The way I see it is that the extension of a taxpayer safety net is a liability that taxpayers take on, and so should be added to the sovereign debt burden of the country. When a government bails out a bank it is converting a private debt into a public debt. Naturally it only does this in the event of a bank crisis, so the obligation is contingent. It is a real debt nonetheless.

Setting aside for the moment the efficacy of such a conversion – and the moral hazard it involves – the existence of a huge potential debt obligation needs to be factored into the risk profile of the national debt.

Why does this matter?

Because we are piling up liabilities at a prodigious rate. The national debt is growing rapidly as the result of our need to prime the economy, and our need to fund entitlement payments even while government revenues suffer a cyclical decline. This growth is causing consternation in the more right wing elements of the financial media because there is a fear we may eventually be charged more for the debt we issue. So far there is no sign of that happening: the government seems to have easy access to a large enough flow of funds, which indicates that the debt fear argument is more ideological than economic. Nonetheless it goes on.

My point then becomes this: our debt burden is growing and is making fiscal policy difficult over the medium term. We will no doubt have to resort to a combination of tax increases and spending cuts to get the budget back in line. Crucially: this adjustment period will be a highly sensitive one. We will have little room for maneuver should another crisis erupt. This lack of wiggle room is the basis for my continued criticism of the Reagan/Bush strategy of starving the government of revenues. No one is seriously going to slash spending on entitlements in the midst of a crisis – cutting them would exacerbate the drop in demand, and the existence of entitlements adds a huge ballast to the economy offsetting the volatility of the private sector. One overlooked aspect of the crisis is the value social programs play in keeping cash flowing in the face of a freeze up of private spending.

But the lack of wiggle room is made much worse by the continued contingent liability we have to bail out the banks. The implied addition to our debt load overhangs any ‘on the books’ policy decisions. Put another way: the bank bail out liability could serve as pressure to cut social spending in order to free up debt room for the banks.

In that light I wanted to see strong measures in the reform that would cut back the contingency.

One way, which is included in the proposal, is to force the banks to pay an up front fee that is set aside as a ‘rainy day’ fund for the government to dip into when it needs bail out cash. I am skeptical about this fund, not because it will not exist, but because it looks insufficient at $50 billion. This insufficiency stems from two weaknesses in the reform proposal: the sheer size of the industry dwarfs $50 billion so a systemic failure would flow straight into our debt burden; and even if the problems were contained to individual banks, those banks are still behemoths, each quite capable of absorbing $50 billion – the cost of saving AIG was much more than that.

And this is my central criticism of the proposal. It leaves the banks too large. It contains fine words about establishing a process to dissolve big banks, and to suggest limits on them. But this puts the burden of change on the shoulders of the regulators, a group prone to capture and intimidation by the industry.

Proper reform, in my view, would have included some form of cap on bank size, backed by the Volcker rule to eliminate over-entanglement and unmanageable complexity.

The contingent liability implied by ongoing taxpayer support should have provided a rallying point for fiscal conservatives to support the establishment of size limits – one way to reduce future budget deficits and limit the fiscal risk of the country is to limit the size of our banks.

Such is the power and importance of the banking industry that we need to take both its instability and incompetence into account as we manage our way out of the hole it dug for us in this crisis. Which is why any reform has to have a harder edge than the Dodd proposal has. So far at least.

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Bank Reform

Well here we go. Lest you have forgotten, we had a bank crisis a while back and such was its ferocity that the economy stalled and approximately 8.5 million of our fellow citizens lost their jobs, while millions of others lost homes. So much for the little details. Now let’s get on with the grown up stuff: how do we avoid this happening again? We need swift, decisive, and deep surgery on our financial system in order to re-align it with socially acceptable goals.

Yawn.

What seems a lifetime later, Senator Dodd sends us his proposal. The only criterion we need apply to it is a simple one: would these reforms prevent a similar crisis.

Umm. Well no, actually.

And therein lies the rub.

The problem I have with the proposal is that it has become a long list of fudged responses. It looks as if it gathered dust over the last year, and that the delay gave enemies of reform plenty of time to soften its blow.

Let’s take a look at it.

First up is the Consumer Protection aspect. On the surface the reform delivers the goods: an agency dedicated to protecting consumers from the kinds of exploitation and misdirection that swamped us with sub-prime mortgages. The new agency would extend its reach into parts of the system that were beyond regulation before and would be adequately staffed and financed to keep up with the legal road blocks thrown in its way by the banking industry. The proposal litters the word ‘independent’ all over the place which is our first indication that all is not well. The good news is that the new agency would take over in a central location all the various consumer related efforts now scattered across the regulatory landscape. The bad news – really bad news – is that this so-called independent agency would sit inside the Fed. This is the same Fed that was clueless as the sub-prime tsunami rose up a few years back.

Having the head of this ‘independent’ agency report to the President does nothing to hide that fact that the Fed has won a decisive battle here. For the new agency to have teeth it needed to stand alone. Dumping it into the Fed’s lap doesn’t fill me with confidence.

Second: having said all that the reform proposal has good things to say about the Fed itself. Good in the sense that it seeks to alter the Fed’s make-up. Currently the Fed banks, and especially the New York Fed which is the key player in the system, are riven through with nasty conflicts of interest. The banks themselves appoint many of the governors and there are far too many career paths that crisscross between the Fed and the banks. This interconnection may not be illegal, and it may not, necessarily, bring about conflicts of interest that have damaging consequences, but it does produce a remarkable homogeneity of thought on the larger banking issues. It allows the skeptics like myself to wonder out loud about the way in which policies were arrived at: why, for instance did the New York Fed seemingly bend over backwards to get Goldman and others that AIG cash? Was it because the chairman of NY Fed at the time was an ex-Goldman executive who still had large Goldman shareholdings? Maybe not. But the conflict was potentially there. In a good system it would not.

The current proposal wins points for eliminating the possibility for conflicts of interest by getting rid of the bank influence on appointments and preventing career jumping back and forth. The Fed will thus be a more independent institution. Whether it will still suffer from finance industry group think is another story.

Third, and this is a major point, the proposal punts on ‘too big to fail’. It recommends a new central committee to oversee ‘systemic risk’ and gives it the power to suggest action against firms deemed dangerously large. The problem is in the details. For instance, the reform would allow this committee to take action against a dangerously large firm, but ‘only as a last resort’. Huh? What does that mean. In the cautious and litigious world of regulation those words: ‘only in the last resort’ signal that the power is never to be used. Who would determine when the last resort had arrived? This is unnecessarily contentious. It shows a weak hand. It is almost as if the writers of the proposal wanted to check off all the big issues and make it appear as if they had dealt with them, and then they backed away in fear of rocking the boat too much. This systemic risk committee smacks of bureaucratic gridlock even before it gets set up. The big banks will be able, I imagine, to thwart anything intrusive coming out of such a cumbersome and purely ‘suggestive’ body.

Fourth, likewise, the reform hedges much too much, on other aspects of the overly complex nature of our big banks. Yes the proposal sets up a center of expertise to gather and analyze the data necessary to understand the dangers the big banks pose to us. But much of that data already exists elsewhere in academic studies. We already know that they are dangerous. We already have tons of data to tell us that financial systems are inherently unstable and need heavy regulation and strong limits on behavior. We do not need more studies, we need to act on the studies that already exist.

The good news on bank complexity is the inclusion of the Volcker Rule, which would go part way to reducing the damage the banks can do. But it is insufficient. We need to reduce the banks in size so that they can be exposed to market discipline.

Nothing in this proposal implies smaller banks. The words are all there, but the action is not. The reform backs away from setting hard limits on size, and relies far too much on soft methods to contain the damage.

Chief amongst these soft methods is the heavy reliance on improving the way in which banks can be wound up through bankruptcy. One of the big problems in the depths of the crisis was the feeling within the Fed and other regulators that they did not possess the power to force a wind up of a defunct bank. Nor are the bankruptcy laws amenable to a swift dissolution – as the ongoing legal battles over the carcass of Lehman attest. It is absolutely vital that a bank can be wound up within a day or so. That way the potential for a cascade of panic and the resultant bank run is eliminated. The point is to limit the damage a rotten bank can do to the system. Unfortunately having any number of good plans and intentions doesn’t always produce the decisive action needed in the heat of the moment. Policy makers and regulators will still be loathe to wind up something as large as Citigroup, no matter how awful its balance sheet has become.

Which is why I am an advocate of taking the action up front: limit the banks in size, so that if they are toxic they can fail without intervention. I am too skeptical of the willingness of regulators to forces a major bank into bankruptcy for me to see much value all the elaborate ‘funeral planning’ that the proposed reform offers up as a bulwark against future bail outs.

And the notion that the banks will be taxed so that a bail out fund can be established up front – to the tune of $50 billion – in order to avoid future TARP like crises is window dressing. The cost of that tax will find its way into customer prices. So we pay either way.

Fifth, the proposal tackles the tangled web of regulation. Or tries to. It reduces and cleans up the mess of regulators we have But it leaves the Fed at the center dealing with the big banks. Which is a bad idea. The Fed failed before in it regulatory role, and shows no sign of strength since the crisis. It still is ‘suggestive’ rather than ‘enforcing’, it still deals with the big banks from a weak position, and it still suffers from that group think I mentioned earlier. So while the reform goes part way to establishing better regulation, it has this basic flaw – in my view – at its core.

Sixth: I support the proposal to bring all the shadow banking system under regulatory supervision. In particular systemically important hedge funds will now brought into the net of control. This is simply an extension of the old ‘if it quacks like a duck’ measure. If an organization could be eligible for public support then it should be subject to public scrutiny. That the proposal moves towards a more comprehensive regulatory regime is to be welcomed. I give this idea high marks.

Seventh, in a similar vein, tightening the net around the insurance industry is a long overdue reform. Right now the insurance industry falls outside of federal oversight. This is despite the size of some of the players in that industry and their potential to do enormous damage to the economy – think AIG. So getting them under control is something we need to do both for consistency’s and safety’s sake. The problem is that the reform doesn’t do this. It merely sets up a federal office of insurance oversight at the Treasury Department, with the remit to look into how to regulate the industry. Ugh. This is a total cop out. The problem is that the state insurance overseers have enormous political clout and will not give up their powers easily. Our chance of modernizing the insurance industry is near zero. Nice idea though.

Eighth, the rating agencies take a hit. Again the reform backs off making a strong move in favor of a list of suggestions and minor tweaks. Yes there is a new office of oversight at the SEC, but this is the same SEC that has perennially bent over backwards to avoid confrontation with a ratings industry riddled through with conflicts of interest. What would have been so hard to eliminate those conflicts? All we needed to do was to fund the rating companies from a tax on the transactions they rate. So rather than rely on the investment banks for fees the rating firms would be quasi-utilities funded from the pool of debt and equity offerings. This would help insulate them from the obscene tampering they were exposed, and fell for, in the go-go years of securitization.

Speaking of which, and last on our list, is the proposal to regulate and bring more transparency to the derivatives market. One of the biggest issues during the crisis was that so many of the toxic transactions were the result of murky and obscure deals done in private rather than through an exchange. This meant that the advantages of an exchange – open pricing, transparent trading, and market making – were lacking. The result was a mess of ridiculously complex and ill understood deals whose value was lost beneath mounds of smart legalese designed to prevent anyone knowing the value of what they had bought, and which masked the consequences of changes in the economic assumptions that made the deals profitable. One of the main ways in which the big banks manipulate the credit markets to their own advantage is through these murky deals. The very name they use for the space in which they trade is a give away of their intentions. They use the phrase ‘dark pools’ to describe it. So getting derivatives out of these dark pools and onto a public exchange is a very good thing. We can give the proposal high marks on this. At least for the attempt.

OK.

Let’s all come up for air.

What is the overall conclusion?

I come out this way: the reform proposal contains lost of good intentions and some good actions. But it falls way short of being decisive. The acid test, for me, is this: does it prevent a repeat of the crisis?

To avoid a repeat the reform would have to produce smaller banks, with simplified lines of business, with less ability to manipulate markets, and less able to exploit customers. It should also have put hard limits on the potential loss taxpayers would bear, and would have ensured that shareholders and creditors play an active role in monitoring executive management in order to prevent the kind of excesses – what we call rent seeking – that led to the misaligned incentive structures of the 2000’s.

Does the reform do all this.

No.

It tinkers. It suggests. It guides. And it starts us along the way. But it does not get us there.

The state of our leadership is such that this reform is being touted as strong. It is not. It is more jello than steel. But that si where we are as a nation. We accept weakness as a sign of pragmatism.

Jamie Dimon is right: we should all expect, and accept, regular financial crises. This reform does not forestall a repeat.

And it’s probably going to get watered down from here on, until something gets voted on. That prospect should galvanize us all into demanding better reform.

I doubt we will get it.