On the Gutting of Financial Services Reform

Bloomberg has a well done but disheartening account of the watering-down-to-meaninglessness of financial services industry reform, with the case example being Basel III. Basel III is the latest iteration of capital standards for banks, which is hoped to be implemented more or less true to form by various national bank regulators. Richard Smith has been ably covering the substance of this beat (see here and here for earlier posts) and the details are indeed more that a bit convoluted.

However, Basel III has been touted in the US as the fix for the shortcomings in bank reforms such as Dodd Frank. As Treasury argues, if banks have more than enough capital, you have a lot of room for error on other fronts. But Basel III preserves too many bad ideas of its predecessor, Basel II, such as risk-weightings for various types of assets that lend themselves to gaming; along with risk weighting, a preservation of the problematic role of unreformed rating agencies; allowing big banks to use their own idiosyncratic and often widely varying risk metrics; an obsession with the asset side of the balance sheet, and not enough to the way that liabilities can also blow out when asset prices are under stress. Basel III thus preserves the architecture of Basel II. Andrew Haldane of the Bank of England described how regulation could best contend with a world of uncertainty, meaning risks that cannot be measured:

The financial system may operate in an environment of uncertainty, in the Knightian sense, as distinct from risk.

There is a literature on how best to regulate systems in the face of such Knightian uncertainty. It suggests some guideposts for regulation of financial systems. First, keep it simple. Complex control of a complex system is a recipe for confusion at best, catastrophe at worst. Complex control adds, not subtracts, from the Knightian uncertainty problem. The US constitution is four pages long. The recently-tabled Dodd Bill on US financial sector reform is 1,336 pages long. Which do you imagine will have the more lasting impact on behaviour?

Second, faced with uncertainty, the best approach is often to choose a strategy which avoids the extreme tails of the distribution. Technically, economists call this a “minimax” strategy – minimising the likelihood of the worst outcome. Paranoia can sometimes be an optimal strategy….

Third, simple, loss-minimising strategies are often best achieved through what economists call “mechanism design” and what non-economists call “structural reform”. In essence, this means acting on the underlying organisational form of the system, rather than through the participants operating within it. In the words of economist John Kay, it is about regulating structure not behaviour…

Glass-Steagall was simple in its objectives and execution. The Act itself was only 17 pages long. Its aims were shaped by an extreme tail event (the Great Depression) and were explicitly minimax (to avoid a repetition). It sought to achieve this by acting directly on the structure of the financial system, quarantining commercial bank and brokering activities through red-line regulation. In other words, Glass-Steagall satisfied all three robustness criteria. And so it proved, lasting well over half a century without a significant systemic event in the US.

The contrast with Basel II is striking. This was anything but simple, comprising many thousands of pages and taking 15 years to deliver. It was calibrated largely to data drawn from the Great Moderation, a period characterised by an absence of tail events – more minimin than minimax. Basel II was underpinned by a complex menu of capital risk weights. This was fine-line, not red-line, regulation. In short, Basel II satisfied few of the robustness criteria. And so it proved, overwhelmed by the recent crisis scarcely after it had been introduced.

Now a set of rules this elaborate and complex is also a ripe target for lobbying, particularly when it is a new iteration of a largely familiar system. The incumbents know well what the various choke points and how they might obtain relief from them. They may also have a keener appreciation than their minders of how the whole can be greater than the sum of the parts, how a combination of seemingly minor tweaks can give them a tremendous amount of latitude.

But that view presupposes that regulators had their hearts in coming down hard on the banks. It’s remarkable how, despite continuing high unemployment and yawning government deficits in virtually all major economies, that the meltdown of 2008 is regarded as an artifact of the distant past, apparently of sufficiently little consequence as to merit tough action now. The Bloomberg piece describes, admittedly at a high level, how Basel III was watered down. It’s told from the vantage of the battles Shiela Bair lost; query what other skirmishes were therefore overlooked.

From Bloomberg:

Banks carried out a yearlong campaign to blunt international regulations, arguing that efforts to rein them in would curb lending and impede economic recovery. The lobbying effort was led by the Institute of International Finance, which represents more than 400 financial firms around the world and is chaired by Josef Ackermann, Deutsche Bank AG’s chief executive officer. Ackermann and other IIF members wrote hundreds of letters to the Basel committee, met with regulators and addressed forums from Seoul to Washington.

In June, the group published a report estimating that the proposed capital rules would result in 9.7 million fewer jobs being created and erase 3.1 percent of global economic growth — estimates the Basel committee later challenged…

Banks also reached out to their home regulators, arguing that some rules would disadvantage them more than other nations’ lenders. That helped draw the battle lines inside the Basel committee, according to an account pieced together from interviews with half a dozen members…

The committee agreed in July to narrow the definition of what counts as bank capital, focusing on common equity, which includes money received for selling shares and retained earnings….

The capital requirements might have been stricter had it not been for Greece. Escalating concern that the country wouldn’t be able to service its debt, culminating in a May bailout by the European Union and a $1 trillion rescue package for other member states that may need it, darkened prospects for economic recovery. That led some committee members to bend to bank pressure, according to policy makers, central bankers and others involved in the process.

Yves here. This is remarkable through-the-looking-glass logic. The cost of a financial crisis, in terms of lower future growth, is already baked in. Contrary to the urban legends taken to heart by bank regulators, dealing with banking crises ruthlessly, as in writing down assets, restructuring and recapitalizing sick banks, leads to a higher growth rate. Back to Bloomberg:

In addition to pushing for a higher capital ratio, Bair also argued for a global leverage ratio that would cap banks’ borrowing — something the U.S. has had on its books since the 1980s…

The EU may exclude the leverage ratio when it converts Basel rules into law next year. Several member nations have advocated dropping the rule, people close to the discussions said last month. A majority of the 27 EU countries oppose adopting the ratio, these people said.

“The argument is that this will restrain lending — I hope our colleagues in Europe don’t buy into this,” Bair said in an interview earlier this month.

Recent academic research supports Bair. A July paper by Jeremy Stein, a professor of economics at Harvard University, and two colleagues looked at data going back to the 1920s and found no correlation between higher capital ratios and costlier lending by banks. An October paper by Anat Admati and three other professors at Stanford University concluded that increased equity levels don’t restrict lending.

This result is not at all surprising, particularly since abuses promoted by Basel II have never gotten the airing they deserve. We discussed at some length in ECONNED how the so-called “negative basis trade” allowed traders at Eurobanks to reap multi-million dollar bonuses on profits not yet earned, and never to be earned, by buying and partially hedging AAA-rated CDOs. Those CDO exposures were not simply the reason so many banks nearly keeled over; this trader-driven demand for AAA CDOs helped keep the subprime market going well beyond its sell-by date, thus worsening the severity of the US housing bubble and aftermath.

But since there has been a singular lack of appetite to do adequate forensics into what caused the crisis, since it might prove to be embarrassing to people still in powerful positions, regulators can follow the inertial course of listening to the palaver that the financial services industry puts forward to allow it to continue looting.

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22 comments

  1. psychohistorian

    Why am I not surprised by your posting? The rules have not changed structurally and none are in jail for the past excesses…so they continue.

    At some point one starts to wonder what the real human toll will be of this social criminality. Will the world turn into wage slaves for the rich and will there be debtors prisons again?

    Think about the higher place in heaven Americans will have for their silent adoption of economic slavery of the world for those that control our nukes.

  2. F. Blair

    “Contrary to the urban legends taken to heart by bank regulators, dealing with banking crises ruthlessly, as in writing down assets, restructuring and recapitalizing sick banks, leads to a higher growth rate”

    This has been oft-repeated here, but what’s the actual evidence for the assertion that ruthlessness pays off? In the canonical case of dealing with a banking crisis ruthlessly — Sweden’s nationalization — the economy did not return to growth any more quickly than the U.S. economy did this time around, despite being helped by a massive export boom. And the IMF study of 124 banking crises, which purports to show that writedowns work better, can’t actually tell us anything about the effectiveness (or ineffectiveness) of regulatory forbearance, because it bizarrely excludes the two most relevant American precedents — the Latin American banking crisis of the early 1980s and the commercial real estate crisis of the early 1990s. In both of these cases, regulatory forbearance was the strategy regulators adopted, and in both cases, economic growth resumed quickly and reasonably strongly.

    To make the argument that writedowns and recapitalization are necessarily better for growth, you have to argue that had U.S. regulators forced the major moneycenter banks into receivership in 1982 (as an honest mark-to-market accounting would have required), the U.S. economy would have grown faster from 1983-1986 than it actually did. Given that GDP grew at about 5% annually, this seems highly dubious. You also have to argue that growth rates in the 1990s would have been much higher had regulators forced Citi and Bank of America into receivership in 1991-1992. Again, highly dubious.

    There may be good reasons, both ethical and organizational, for thinking that we should have adopted a tougher approach with the banks. But the argument that the economy would now be growing faster if we’d nationalized is unproven at best.

    1. Yves Smith Post author

      The experience of 124 banking crises, per a very detailed IMF study (were I not having backup problems and about to go to the airport without this computer, I’d cite it, but you can find it if you search this blog). I should be able to add it, but that will be at least 12 hours.

      1. F. Blair

        “The experience of 124 banking crises, per a very detailed IMF study (were I not having backup problems and about to go to the airport without this computer, I’d cite it, but you can find it if you search this blog)”

        I’m familiar with this study (available here: http://www.imf.org/external/pubs/ft/wp/2008/wp08224.pdf), which is why I mentioned it in my comment. But as I said, this study does not prove what you think it proves, because the authors’ definition of “crisis” in effect excludes in advance crises that were successfully resolved via regulatory forbearance. That’s why they don’t include — nor do they mention — the American banking crises of the early 1980s or the early 1990s, both of which were far bigger (in terms of dollars and potential fallout) than nearly all of the crises in their database, yet which were successfully managed via forbearance, and which were followed by periods of strong economic growth. If you do a study that simply ignores the most important counterexamples to your thesis, I think it’s difficult to take that study seriously.

        On top of that, the study’s applicability to the US — and your continued invocation of it — rests on the dubious assumption that managing a banking crisis in developing countries with small and reasonably simple banking systems (the vast majority of the crises in the database took place in developing countries) is analogous to managing a crisis involving the biggest and most complex banking system in history. Again, there is no reason to think that assumption is true.

        The IMF study is an interesting, and useful, piece of evidence. But any serious attempt to deal with the question of how the crisis of 2008-2009 should have been managed has to acknowledge and deal with the fact that regulatory forbearance succeeded in the US in the early 1980s and the early 1990s and had no deleterious impact on economic growth. The fact that the study doesn’t even touch on these questions makes it far less valuable than you believe it to be.

        1. kxmoore

          Bair says “2008-2009 should have been managed has to acknowledge and deal with the fact that regulatory forbearance succeeded in the US in the early 1980s and the early 1990s and had no deleterious impact on economic growth. The fact that the study doesn’t even touch on these questions makes it far less valuable than you believe it to be.”

          see “moral hazard” and “chickens coming home to roost”, “bitter harvest” etc etc,

          1. Cedric Regula

            Also see:

            TBTF-> Basel III + Frankendodd -> Too Complex To Fail (TCTF)-> The FrankenVultures Come Home To Feed (TVCHTF)

        2. YankeeFrank

          Let’s ask this question from another point of view: if the banks had been treated harshly and put in receivership in these prior crises (and the swindlers put in jail) do you think they would’ve been able and willing to carry out the current massive fraud and theft? You don’t need a study to prove that criminals who get away with their crimes are emboldened to try again, usually on a larger scale the next time. So please stop confusing the trees for the forest.

    2. Matt

      One of the larger elephants of bank insolvency in Basel III and other regulations lies in the valuation regulations of the bank long and short derivatives. The incorrect valuation of these derivatives is behind the failure of AIG and the massive interest rate swap swindle of many public and non profit bodies in the US.
      As Buffett wrote in his 2005 letter, “It’s a strange world in which two parties can carry out a paper transaction that each can promptly report as profitable.”
      The derivative business combined with the Enron style SIVs
      have created a hidden Ponzi money supply that is off the books of both the banks and the regulators.

  3. hermanas

    “The lobbying effort was led by the Institute of International Finance, which represents more than 400 financial firms around the world and is chaired by Josef Ackermann, Deutsche Bank AG’s chief executive officer.”
    Is this the same Deutshe Bank that just paid a half billion dollar fine for criminal activity? How big a stretch is it to think criminals are writing the rules?

  4. Jack Rip

    This comment addresses a marginal issue tat goes through most of the post: the complexity and volume of the new rules. Far from being confined to financial problems, complexity is typically a failure to make concrete, direct and simple rules. The financial industry excels at blowing complex smoke that created the financial collapse. In many cases, complexity is put in to allow criminal activities to continue. Dodd-Frank should be 10 pages long. Its current excess of 1300+ pages is a Chinese torture by a 1300 needles. (The same is true about the alleged health care reform that got to weigh like a Ford F-150 because it wanted to avoid the public option and make the health insurance companies even more abusive.)

    The Glass-Steagall act was brief to make the rule black and white with no shades of gray. Dodd-Frank is anything but brief because it allows a million shades of gray. As citizen, we are paying for the shades of gray while the financial industry gets to continue its control over us.

    1. readerOfTeaLeaves

      a marginal issue tat goes through most of the post: the complexity and volume of the new rules. Far from being confined to financial problems, complexity is typically a failure to make concrete, direct and simple rules. The financial industry excels at blowing complex smoke that created the financial collapse.

      As I read them, both Yves’ “Econned”, and also Bookstaber’s “Demons of Our Own Design”, address complexity as one of the key problems muddying the financial waters. Indeed, it muddies human thinking.

      But it’s a perfect mask for fraud.

  5. financial matters

    Would like to see Sheila Bair as Treasury Secretary, but first let her pick her own replacement at FDIC. I seem to remember some article calling financial execs ‘Bair Bait’.

    I think the point can be made that Obama inherited a ‘no-win’ situation. He decided not to take the banks on broadside but tried a more moderate approach. But the finanical executives made off with huge bonuses while the taxpayers paid the bill. This helped lead to the huge midterm Republican wins. But if he would have nationalized the banks 2 years ago he would have been labeled a ‘socialist’ and it’s not as if the economy would have miraculously rebounded, it was too damaged. But now that the extent of the bank fraud is becoming more evident to the American public, prosecution of this fraud and a more broad takeover of the banks (read receivorship) would be better tolerated and in fact be the strong card he needs to play to opt for a second term….

    1. Billy Bob

      “… the extent of the bank fraud is becoming more evident to the American public …”

      Is it? I certainly wish the President would use his bully pulpit to explain the harm that banks and other financial institutions have done to the US and world economies. But I would first like to see some indication that his administration is aware of that harm and has a workable plan to fix it.

    2. ZADOOFKA FLORIDA

      I would like to see Elliott Spitzer made czar of housing recovery. No, not like the “car czar”, a fraudster made a dog with no teeth, but one to make the needed changes, against the processors and against the fraud called “HAMP”

  6. Norman

    Perhaps this may be a naive question, but having read this post & others religiously these past 3 + years, especially all the different opinions, facts, etc., of this latest screw the taxpayer episode from the Financial, Government and assorted other entities, along with some of the written books, “Why” haven’t you & the other members who have the knowledge, experience, voice, unified around a solution, one that has the unanimous consensus of the whole, so that it can be presented to the public, the powers to be, then perhaps there just might be a positive change! I’m sure that the ones who control the votes, (bought & paid for) won’t take kindly, but to point up to the vast citizens a solution instead of the constant barrage of Political fear tactics that are bantered around today, which I might add, is having the intended effect. It’s perhaps well intentioned to write & speak about the failings, but with so many voices coming from all the different outlets, except the MSM, it’s too difficult to wrap the arms around. I really hate to think that this country is going to lie down and die, just because greed, corruption, Government sycophants, are tearing the laws, regulations, enforcement down.

    Excuse me for being long winded, and I’m sure others may feel this irrelevant, but considering my age, 72, it makes me sad to know that there are good & just solutions, without having to resort to violent overthrow of the present status quo. Whether what I ask is doable, I don’t know. But only fools believe that this can continue in its present form.

    1. LeeAnne

      Get rid of US/UN drug prohibition enforcement policy. Governments are hooked on and run by drug money; their police organized all over the world by the policy that is now being used against peaceful demonstrators. The profit making prison system with the largest prison population in the world is a travesty.

      Look to see how the least among us are being treated. That’s your country.

      Is $380,000,000,000 suddenly chump change? Is the 5% charged to the criminal banks for drug money laundering a penalty? Really?

      The illegal drug industry is the easiest explanation for some of the incongruities being committed by the US government all over the world: open Mexican borders, military protection of Afghanistan poppy growing, mercenary troops, National Guard co opted from their duties locally replaced by federal mercenaries not subject to rule of law; citizens secretly deputized to function without rule of law in the case of inevitable marshall law permitted by decree, tampering with Internet speech and money transfer; corporations operating with no rule of law …. on and on …..

  7. arby

    The American public remains uninformed on the very basics of what has happened to their economy. During the holidays, I have been asking friends and relatives two questions: name the three largest recipient banks of Fed help for their special needs and bane the total dollars the Fed committed through its own devices outside of TARP to rescue the banks. There has yet to be a person – all of them with college degrees or better – who has gotten the answer to either question or even in the ball park. When they find out the answers, they cannot believe it and usually have some variant of denial or “why don’t we get told that?” I have the web addresses for the deniers to check the source and the analysis; there is good answer for the others.
    Suffice it to say that a President intent on fixing the economy for the general good would be fixing the broken engine of American capitalism which is now serving a narrow set of interests. This President is not intent on fixing the economy for the general good.

    1. Tim Goswell

      I’m finding the same kind of thing, only worse, whenever I raise this issue among family, friends or co-workers: appalling ignorance and an almost universal belief that the TARP money was paid back, that it was a success done with the best intentions for the general good of all Americans, perhaps all of mankind, etc

      As if our politicians and the corporate media can always be relied on to tell the truth.

      Either it’s complete denial or “why don’t we get told that?”
      And this mostly from people who have a college education.

      It’s discouraging, Noam Chomsky was right when he said “Propaganda is to a democracy what the bludgeon is to a totalitarian state.” No need to use a bludgeon with these people, as propaganda is working just fine.

      On the other hand, there’s one encouraging sign: if I speak to working people about these matters, people who have not been subjected to a higher education, they may not know the details related to the bailout, but in my experience, they’re far more likely to be skeptical of all the bullshit and propaganda.

      At least the ones I’ve spoken have no problem understanding that the Bailout was nothing but theft, and that our politicians are nothing but a bunch of liars and crooks.

      So my overall impression is that the working class “gets it” however the college-educated middle class is still unable to connect the dots.

  8. 60sradical

    A question to a couple of above bloggers: did real taxpayer
    money pay for TARP plus the other massive financial bailouts(in the trillions of $$)OR was it FIAT CURRENCY electronically generated by the FED? Posterity must deal wth this crime and wait till the CDS start to unfold globally. Just sayin’.

  9. Random Blowhard

    The meltdowns will CONTINUE until the incentives that drive them are changed or the entire system nukes itself out of existance. One of these events WILL occur.

Comments are closed.