Richard Smith: US Financial Reform – Tracking the Rabbit Through the Anaconda

By Richard Smith, a London-based capital markets IT consultant

Tracking the changes to the US financial reform package in minute detail would drive you nuts. But there is a quick and dirty alternative: simply compare the Geithner/Summers trailer from July ’09 with the latest one (Geithner, solo, last week, Thursday 6th May, 2010). They each have their list of highlights, and the highlights have changed. No doubt, the changes illustrate the evolution of political imperatives, but they do give an idea of where to look for changes in the legislation, too. Which seems a less grim way to get an overview than tracking through deltas and carve-outs in 1,500 pages of fast-changing legalese. Are the changes merely better spin, with more some more intrusive elements to persuade the skeptics, plastic surgery instead of mere pancake and rouge? That will take more of a dig to assess, and more posts.

The old, depressing, July ’09 trailer is here…and here is the frame:

This current financial crisis had many causes. It had its roots in the global imbalance in saving and consumption, in the widespread use of poorly understood financial instruments, in shortsightedness and excessive leverage at financial institutions.

Waffly, this. One can’t expect financial regulation to do much about the global imbalance. Mentioning it up front just diverts attention from the failures that really can be addressed by US regulation. The same goes for “the widespread use of poorly understood financial instruments” and “shortsightedness…at financial institutions”. Indeed: there was ignorance and folly, and this is planet Earth. Still, the leverage point is valid, and the prevarication does fizzle out eventually:

But it was also the product of basic failures in financial supervision and regulation.

Next we get a sighting of “systemic risk”, with promises of capital and liquidity requirements (to be tougher for TBTFs), Fed supervision, and a ‘council of regulators’.

First, existing regulation focuses on the safety and soundness of individual institutions but not the stability of the system as a whole. As a result, institutions were not required to maintain sufficient capital or liquidity to keep them safe in times of system-wide stress. In a world in which the troubles of a few large firms can put the entire system at risk, that approach is insufficient.

Next, some missed points and canards:

Second, the structure of the financial system has shifted, with dramatic growth in financial activity outside the traditional banking system, such as in the market for asset-backed securities. In theory, securitization should serve to reduce credit risk by spreading it more widely. But by breaking the direct link between borrowers and lenders, securitization led to an erosion of lending standards, resulting in a market failure that fed the housing boom and deepened the housing bust.

The now-incredible theoretical claim that “securitization…reduce[s] credit risk by spreading it more widely” makes what I hope is one of its final appearances. Erosion of lending standards is only part of the point about securitization – where’s its connection to the shadow banking system, exactly. In fact, they don’t display much of an idea of the scale and importance of shadow banking here at all. Then:

The administration’s plan will impose robust reporting requirements on the issuers of asset-backed securities; reduce investors’ and regulators’ reliance on credit-rating agencies; and, perhaps most significant, require the originator, sponsor or broker of a securitization to retain a financial interest in its performance.

The plan also calls for harmonizing the regulation of futures and securities, and for more robust safeguards of payment and settlement systems and strong oversight of “over the counter” derivatives.

All derivatives contracts will be subject to regulation, all derivatives dealers subject to supervision, and regulators will be empowered to enforce rules against manipulation and abuse.

Jolly good. But there’s not much sign here that the plan understands the difference between the tamer kinds of OTC swaps (IRS and the like), and CDS. Part of the problem with CDS is that these instruments provide yet another way to get yield from highly illiquid assets. It’s another variant of that run-prone, systemic-risk-generating shadow banking game.

Then we get a quick reminder of one of the casualties, or at least, disappointments, of the political process:

Third, our current regulatory regime does not offer adequate protections to consumers and investors. Weak consumer protections against subprime mortgage lending bear significant responsibility for the financial crisis. The crisis, in turn, revealed the inadequacy of consumer protections across a wide range of financial products — from credit cards to annuities.

Building on the recent measures taken to fight predatory lending and unfair practices in the credit card industry, the administration will offer a stronger framework for consumer and investor protection across the board.

Then another oblique self-exculpation, followed by the debut of the resolution authority.

Fourth, the federal government does not have the tools it needs to contain and manage financial crises. Relying on the Federal Reserve’s lending authority to avert the disorderly failure of nonbank financial firms, while essential in this crisis, is not an appropriate or effective solution in the long term.

To address this problem, we will establish a resolution mechanism that allows for the orderly resolution of any financial holding company whose failure might threaten the stability of the financial system. This authority will be available only in extraordinary circumstances, but it will help ensure that the government is no longer forced to choose between bailouts and financial collapse.

Lastly, a bolthole for regulatory arbitrage, dressed up as a statement of US leadership:

Fifth, and finally, we live in a globalized world, and the actions we take here at home — no matter how smart and sound — will have little effect if we fail to raise international standards along with our own. We will lead the effort to improve regulation and supervision around the world.

So, none of that, back in July 2009, looked very promising: a weak analysis of the causes of the crash, some disjointed looking proposals, some mild BS. Kind of picking at the problem, with lobbyists at the ready.

But what is the result of nine months’ thought and some horsetrading with concerned Congressmen, juggling lobbyists and angry voters? This time around the key quote on the background (and thus the rationale for the reform) looks somewhat different:

[the New Deal] regulatory system did not evolve to keep pace with growth and innovations in our financial services industry.

Hah – no, it’s not so much that didn’t fail to keep pace with innovation. It was gutted, drilled full of holes, arbed, and gamed, to *facilitate* “innovation”. This was, as Yves would say, a feature, not a bug. But I shouldn’t interrupt:

The constraints imposed by banking regulation were significant enough to encourage activity to move away from banks in search of lighter regulation, lower capital requirements, weaker consumer protections, and better tax and accounting treatment.

Over time, the size of this parallel banking system grew to the point where it was almost as large as the entire traditional banking system. At its peak, this alternative banking system financed about $8 trillion in assets. Many of these assets were financed with short-term obligations and in institutions or funding vehicles with substantial leverage – leaving them with relatively thin cushions of resources to protect against the possibility of loss.

This parallel system came in many shapes and sizes. Independent investment banks like Lehman Brothers and Bear Stearns grew in size and financed themselves in the overnight repurchase agreement, or “repo” markets, which rely on assets or securities as collateral. Asset-backed commercial paper (ABCP) conduits and structured investment vehicles (SIVs) were used by banks and a broad range of other financial institutions as funding vehicles for different types of assets. Specialized finance companies expanded into a broad range of consumer and business lending activities.

Now, that’s actually more like it. It’s almost as if someone had at last read Henry Maxey’s piece. Here are the points in the speech that emphasize the shadow banking system. Some are new, some are revamps of July’s ideas with a much sharper focus:

Comprehensive Constraints on Risk Taking

. The constraints will encompass the likes of non-banks like LEH and AIG, to “level the playing field”.

Repo Markets

. A whole new swathe of regulation for repo: applying capital & collateral standards, introducing settlement procedures, and giving (someone) enforcement authority.

Higher Standards for Money Market Mutual Funds

. The intention is to augment newly introduced SEC rules on MMMFs, in order to reduce the susceptibility of money funds to runs. (MMMFs are another kind of risk-taking, undercapitalised shadow bank).

Rating Agencies, Disclosure, and Accounting

. Some bits old, some bits new. Includes requirements for disclosure down at loan level for ABS, fun for some system designer. It’s so nice to see the accountants get a mention at last. And we are promised some reform of the RAs, to “limit conflicts of interest, require greater disclosure to ensure more diversity in ratings, and require regulators to reduce the overall reliance on ratings”. Peachy!

So the shadow banking system is now front and centre. Overall, that is quite a shift. Capital and liquidity requirements, securitization, ratings agencies, which all got a mention back in July out, are all now put in the context of shadow banking. “Systemic risk” is not as conspicuous a concept in the new version as it was in the old. This seems right: “shadow banking” is indeed a much more accurate point d’appui.

That gruesome piece about product structurers retaining a financial interest in their products post-sale is a welcome omission (perhaps Geithner and his staff understand a bit more about spread trades now).

The call for international standards is gone (except for some flapping at accounting standards); presumably, because Geithner thinks Basel III is coming soon enough. Don’t get your hopes up. If the progress of Basel II between finalization and live use is any guide, even the early adopters who start preparing to comply with Basel III ASAP won’t be live with it until 2016 or so. That’s based on BIII’s being finalised in 2012, plus four years of implementation work for local regulators, consultants, systems guys, and bank management.

That leaves two points with roughly the same emphasis that they had back in July, though the detail has changed: Derivatives and the Resolution Authority.

Derivatives reform now involves central clearing, margining, prudential standards, SEC enforcement and (and!) CFTC enforcement. Note that Geithner doesn’t seem too thrilled with section 106 of the Lincoln proposal on Derivatives Regulation, the presumed target of this Geithnerian squeak:

When people look back at this crisis, when they look at the excessive risks taken by large financial institutions, the natural inclination is to move those risky activities elsewhere. To create stability, some argue, we should just separate banks from “risk.

But, in important ways, that is exactly what caused this crisis.

The lesson of this crisis, and of the parallel financial system, is that we cannot make the economy safe by taking functions central to the business of banking, functions necessary to help raise capital for businesses and help businesses hedge risk, and move them outside banks, and outside the reach of strong regulation.

Lastly, the resolution proposal hasn’t changed much.

So the high level summary of the status quo would be:

• The shadow banking stuff now looks appropriately targeted, by and large. They have sort of got it. Doubtless there will be nits to pick, down in the detail.
• There is a half-acknowledged dependency on Basel III. Not sure that could be avoided, really.
• There is plenty of controversy about the Derivatives proposal. CDS and other derivatives are still lumped together. It would be good to understand more about how these high level proposals on derivatives translate into specifics on CDS, but that will have to wait for more digging.
• On its face, the Resolution Authority proposal seems just as vague and aspirational now as it was last July. That will take more digging.
• The Volcker rule didn’t make it into the official legislation (there is a version of it in the Merkley-Levin amendment, though).
• Consumer protection plays Cinderella.

To be honest, at this level of description the proposals don’t look quite as horrific as they might have done (after TARP et al, one’s expectations were modest indeed). So should one hold out for more, or quite a lot more? Is perhaps this – all holes and no cheese – still the right take on what will emerge?

Oh dear, I am running out of ways of postponing a look at the ever-shifting detail. At least I can do my own round-up of important things I can’t find in the proposals; in my next.