I want the word “reform” back. Between health care “reform” and financial services “reform,” Obama, his operatives, and media cheerleaders are trying to depict both initiatives as being far more salutary and far-reaching than they are. This abuse of language is yet another case of the Obama Adminsitration using branding to cover up substantive shortcomings. In the short run it might fool quite a few people, just as BP’s efforts to position itself as an environmentally responsible company did.
Witness some of the headlines today that no doubt give Team Obama cheer: “Big banks face ‘jarring shake-up’ from new regulations” (MarketWatch); “U.S. Lawmakers Set Historic Finance Deal” (Wall Street Journal); “In Week of Tests, Obama Reasserts His Authority” and “In Deal, New Authority Over Wall Street” (New York Times).
But the market action said it all. On a flat trading day, financial firms shares rose 2.7% after the deal was announced. And the Financial Times (the only financial news purveyor whose reporters and columnists were savvy enough to recognize the credit bubble and indicate it was likely to end badly) gave a wonderfully understated diss:
If approved as expected, the legislation would mark the most dramatic change in financial rules since the 1999 repeal of the Depression-era separation of investment and commercial banking. It would pave the way for President Barack Obama to claim, after the recent healthcare reform, his second key legislative victory.
Yves here. This is simply arch. To appreciate the significance of the comparison to the 1999 Glass Steagall repeal, you first need to compare it to the PR in the US press, which touts the bill as the most sweeping reform since the Great Depression. The FT isn’t buying the hype. Moreover, the Glass Stegall repeal was even less significant than the headlines then or more recent commentary would suggest. Why? By 1999, Glass Steagall was so shot full of holes with all regulatory waivers that it was close to a dead letter. Banks had been obtaining variances since the 1980s. By the mid 1990s, securities firms were making bridge loans and the biggest banks were increasingly influential in derivatives, stock, and bond underwriting.
So why was Glass Steagall dismantled? Banks were still restricted to making no more than 25% of revenues in their securities operations. The main reason for the repeal appears to have been to allow the merger of Citigroup and Travelers (which owned securities firm Salomon Smith Barney) to proceed.
And note the wording of the second sentence: by commenting Obama’s “legislative victory,” the pink paper dares suggest that the most important outcome of the bill’s passage is in giving Obama another notch on his belt.
So what does the bill accomplish? It inconveniences banks around the margin while failing to reduce the odds of a recurrence of a major financial crisis.
The only two measures I see as genuine accomplishments, the Audit the Fed provisions, and the creation of a consumer financial product bureau, do not address systemic risks. And the consumer protection authority was substantially watered down. Recall a crucial provision, that banks be required to offer plain vanilla variants of products, was axed early on. In addition, the agency, initially envisioned as independent, will now be housed in the Fed, which has never taken any interest in consumers (witness its failure to enforce the Home Owners Equity Protection Act, a rule which would have limited subprime lending) and has a long standing hands-off posture towards its charges.
Most of the rest is mere window dressing. The Volcker Rule was substantially watered down. Banks can still own private equity and hedge funds so long as they do not exceed 3% of core capital. There is no justification, nada, for organizations enjoying state guarantees to engage in anything other than socially useful activities that cannot be readily provided by outside players. Nevertheless, Goldman may have to reduce its PE and hedge fund exposure by as much as $10 billion, and Morgan Stanley, $3 billion. While there are purported to be limits on proprietary trading, the latest state of play was to designate transactions with customers as not being prop trades, an absurd definition given the intent of the provision (I must confess I have not seen the final language, so any reader input here would be appreciated).
From a systemic risk standpoint, the two most important things that needed to happen were greatly increased equity levels (this would need to take place gradually) and a reduction in the “tight coupling” of the major capital markets firms. Right now, the top dealer firms are part of a badly designed network, where if one node goes down, it can bring down the entire grid. Neither was tackled in a serious way.
The most important two products to address in term of the excessive interconnectedness of financial firms were repos and credit default swaps. The New York Fed has been soldiering along on repo, yet is unconvinced of the effectiveness of its changes (!); the Blanche Lincoln amendment got reworked into putting the riskiest derivatives, including CDS, into a separately capitalized operation. Since (as we have discussed at length) CDS are not economic if adequately margined/capitalized, this measure does almost nothing to defuse the CDS bomb (the same problem exists even if the CDS are cleared centrally, which means the clearing organization becomes a potential AIG, a mere concentrated point of failure. and Alea points out a paper that argues that Are We Building the Foundations for the Next Crisis Already? The Case of Central Clearing” the central clearing organization could actually INCREASE counterparty risk).
We will address the resolution authority headfake separately, later this weekend. Suffice it to say that all the major firms have significant international operations, so you can’t design a new improved resolution regime from the US alone. Bankruptcy is an adjudicated process, subject to the national laws of host countries. I am told by someone in a position to know that none of the 30 to 40 lawyers in the world competent to advise on this matter were consulted on the legislation.
A sampling of comments on the bill. From Michael Hirsh of Newsweek, “Financial Reform Makes Biggest Banks Stronger“:
Dodd-Frank effectively anoints the existing banking elite. The bill makes it likely that they will be the future giants of banking as well. Legislators touted changes that would restrict proprietary trading by banks and force them to spin off their swaps desks into separately capitalized operations. But banks get to keep the biggest part of their derivatives business, which is dominated by interest-rate and foreign-exchange swaps. Some 80 to 90 percent of that business will remain within the banks, and J.P. Morgan, Goldman Sachs, Citigroup, Bank of America, and Morgan Stanley control more than 95 percent, or about $200 trillion worth of that market. These same banks may end up controlling or at least dominating the clearinghouses they are being pressed to trade on as well, since language proposed by Rep. Stephen Lynch, D-Mass., to limit their ownership stakes to 20 percent, was dropped in the final version of the bill, according to Lynch’s spokeswoman, Meaghan Maher. “No numerical limitations were set; regulators were given the ability to do so,” she said.
The bill leaves many other future decisions, for example on pay structure and incentives, to regulators as well. “The bottom line: this doesn’t fundamentally change the way the banking industry works,” says a former U.S. Treasury official who has followed the legislation closely but would give his judgment only on condition of anonymity. “The ironic thing is that the biggest banks that took the most money end up with the most beneficial position, and the regulators that failed to stop them in first place get even more power and discretion.”
From Marshall Auerback:
The whole approach to financial reform has failed to deal with the core problems with gave rise to the crisis in the first place. Credit default swaps, collaterised debt obligations, etc., need to be understood as key components of an integrated system, the so-called “shadow banking system”, which was at the epicenter of the crisis…..
As Jan Kregel has noted…“the liquidity crises in 1998 and 2008 produced, not a run on banks, but a collapse of security values and insolvency in the securitized structures, and the withdrawal of short-term funding from the shadow banks. The safety net created to respond to a run on bank deposits was totally inadequate to respond to a capital market liquidity crisis.”
The new “financial reform” bill merely reflects the model of a banking structure which was already largely gone by the time we abolished Glass-Steagall. The proposed bill fails to recognise that in a capital market-based credit system, the key player is not the bank that originates and holds the loan, but rather the dealer who makes liquid markets in the security into which the loan is bundled. In such a system, the focus of regulation should not be on the capitalization and liquidity of banks per se, but rather on the capitalization and liquidity of dealers….
Ideally, systemically risk products such as credit default swaps should be abolished, as they serve no public purpose. But this is impossible in the real world. Pandora’s Box has been opened and can’t be shut again.
The problem with today’s reform is that sellers of credit default swaps without an adequate capital cushion may be required to post collateral on an exchange, which raises the question, “How much collateral is enough?” AIG clearly didn’t have enough. Potentially, no private financial institution does…
We should also impose greater regulatory oversight on the products emerging from this capital based market system. There is no reason why the SEC could not rescind rule 3a-7, which has exempted securitised structures from registration and regulation under the Investment Companies Act. This rescission would functionally act like a Tobin tax insofar as the resulting higher regulatory thresholds would likely slow down the proliferation of new securitised products, as well as imposing a great fiduciary responsibility on the issuer.
From Bill Black:
The fundamental problem with the financial reform bill is that it would not have prevented the current crisis and it will not prevent future crises because it does not address the reason the world is suffering recurrent, intensifying crises. A witches’ brew of deregulation, desupervision, regulatory black holes and perverse executive and professional compensation has created an intensely criminogenic environment that produces epidemics of accounting control fraud that hyper-inflate financial bubbles and cause economic crises. The bill continues unlawful, unprincipled, and dangerous policy of allowing systemically dangerous institutions (SDIs) to play by special rules even when they are insolvent. Indeed, the bill makes a variety of accounting control fraud lawful. The financial industry, with Bernanke’s support, already got Congress to extort FASB to gimmick the accounting rules so that insolvent banks could hide their losses and continue to pay the executives (already made rich by destroying “their” firms — that’s the meaning of Akerlof & Romer’s classic article: “Looting: Bankruptcy for Profit”) massive bonuses. All of this is made possible by huge, off budget subsidies to the SDIs via the Fed and Fannie and Freddie.
Even the New York Times conceded, “Industry analysts predicted that banks would most likely adapt easily to the new regulatory framework and thrive. ” That proves the bill falls laughably short of its PR; it would take either a radical restructuring of the industry, or regulating banks like utilities, to reduce the risk of another major crisis.
But despite the hype, the public may not be so dumb after all. Bloomberg tells us: “Obama’s Legislative Accomplishments Fail to Bolster Popularity.” It appears at least some voters can discern the difference between mere optics and substance.