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

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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.

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  1. Mickey Marzick in Akron, Ohio

    “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.”

    This comment bears further scrutiny, particularly the following:

    But by breaking the direct link between borrowers and lenders, securitization led to an erosion of lending standards…

    Two observations are in order:

    1) Why the need/requirement for securitzation on such a colossal scale as to give rise to a “shadow banking system”?; and

    2) Securitization decoupled consumption from production by enabling many individuals/households/companies to multiply their productive capacity [income] beyond what this income stream would normally allow; for many the multiple was a factor of at least 2X or 3X, if not more. Remember the recent past when one received a half dozen credit applications for VISA/MC every week. I once had a MC with a credit limit upwards of $25,000 – subsequently reduced to $12,500 for lack of usage! But recount your own experiences in this regard.

    The first observation has been examined in depth – stagnant wages, outsourcing – on this site so as not to need further explication. So let’s concentrate on the second because it hasn’t been analyzed at length for its longterm ramifications for capitalist market economies.

    In the first place, the expansion of credit has severed the “direct” link between consumption and production. In the past, this linkage was much more transparent with one’s consumption usually tied directly to cash-on-hand or in-pocket or what was canned/stored in the fruit cellar.. The latter was a constant reminder of the “scarcity” of goods for consumption, not because they didn’t exist, but because the ability to purchase them on credit was not available, the company store notwithstandng… Remember “layaway” at the local department store?

    This link between “scarcity” and cash-on-hand has been all but obliterated over the course of the past 30 years. Of course underlying this direct link between consumption and production was a value system predicated on delayed gratification, thrift/frugality, and steady employment/work. [The Protestant Ethic of Max Weber?] How has CREDIT undermined this value system as well as the perception [whether real or not] of the “scarcity” which reinforced it? “Plastic” has created the perception that the stream of goods/services for consumption is endless, enabling significant segments of the population to purchase them without any regard to the conditions underlying their production. “Plastic”, in effect, is the private sector equivalent of Food Stamp monopoly money or WIC coupons. To the extent that the latter have been converted to “cards” swiping either at the grocery store checkout counter has much the same effect – groceries! Of course, the former depends on the “promise to pay” but the result – CONSUMPTION – is much the same.

    So, given this setting, the shadow banking system has, in effect, undermined the value system on which the real economy is based. Mere regulation of the former will not alter this fact. Its continuation and expansion will only exacerbate this situation, blurring the connection between consumption and production and the perception of scarcity. Putting this genie back in the bottle would seem problematical at this point as it has acquired a certain momentum of its own over the course of the past 30 years or so. It would seem that there is a fundamental contradiction between the real economy and the values on which it is predicated and that of the shadow banking system, opening up a rift with profound ramifications for capitalist market economies. The great irony of course is that the shadow banking system, much heralded as the innovative, dynamic force of creative destruction in the latter, has undermined the value system on which the latter depend. Creative destruction indeed!

    AUSTERITY and the shadow banking system would seem to be mutually exclusive or in inverse relationship to one another. The latter has certainly emerged and grown only in the wake of an unprecedented expansion of CREDIT. If AUSTERITY of the kind bandied about by “experts” is actually implemented would there even be a need for the shadow banking system? And how would this impact the real economy? 30 years of deleveraging and deflation to reset the table so to speak is likely to put a severe strain on democratic institutions … in the wake of the decoupling of consumption from production internalized by many over the past 30 years. In other words, going backwards is an option but do we really want to go that route when it may not be necessary? This conundrum leaves me with more questions than answers and articulating it here is wanting insofar as my stream of consciousness is several rivulets coming together at one time. I just don’t know where this leads… or if I’ve stumbled on anything of consequence meriting further analysis. This rabbit has to return to his hole.

    1. James

      Dude, I think you’ve nailed this one about as well as I’ve heard it nailed yet – up to a point. Indeed, AUSTERITY and CREDIT, as you term them, are INDEED the key issues; although as you correctly point out/allude to, another phrase for AUSTERITY might be simply “living within your means.”

      Issues of securitization are well taken as well, but, to my mind at least, really go beyond the key thrust of your post. If you’re talking about Wall Street “fantasy market” securitization issues, well of course, those go without saying as totally destructive. The fact that “normal investors” can’t even comprehend them should be an open and shut case in and of itself.

      The idea of “credit as wealth” is INDEED a PIVOTAL issue facing the ENTIRE global financial market structure as it currently exists. Indeed, I’m surprised that you marched so confidently right up to the precipice of calling for its complete overthrow [Putting this genie back in the bottle would seem problematical at this point as it has acquired a certain momentum of its own over the course of the past 30 years or so. It would seem that there is a fundamental contradiction between the real economy and the values on which it is predicated and that of the shadow banking system, opening up a rift with profound ramifications for capitalist market economies.], and then so timidly walked away [In other words, going backwards is an option but do we really want to go that route when it may not be necessary?].

      In short, you MIGHT have a future as a writer of (well justified) polemics; but DUDE(!), you’ve REALLY got to learn how to close the deal.

      1. Mickey Marzick in Akron, Ohio


        And what does “closing the deal” actually entail? Could you enlighten me with the specifics? Or don’t you have the time? What will we put in its place?

        I’m not presumptuous enough to believe I’ve nailed anything! Merely because there appears to be a “contradiction” does not mean it will be resolved in some mechanistic iron law – historical materialism, for example – that the outcome is predetermined. I’m still not certain what the consequences are if consumption has been irrevocably decoupled from production by the expansion of credit? Are you? Does this mean that socialism/communism is at hand even though significant segments of the population are vehmently OPPOSED to it? Even if they are mistaken – false consciouness, eh? – how does one deal with them within a democratic framework? Or are you suggesting that we go the “dictatorship of the proletariat” route because it’s for their own good anyways?

        There’s no guaranteee that going backwards – AUSTERITY – will not become the preferred choice of the ruling class and the American people even if the “shadow banking system” has to be sacrificed. A return to the “good old days” where an individual lived within his/her means – a much reduced standard of living imposed from above – is not impossible, is it? Just ask the Greeks, Chileans, or Argentinians…. But do you want to go back to the good old days when they aren’t necessary?

        I just don’t see how the “shadow banking system” can continue to exist/expand if the credit spigot is turned off. But that’s not to say that it can’t be turned off over time – AUSTERITY. There are many “loose ends” that remain to be worked out… to which I don’t pretend to have the answers. If you’re saying that I’ve nailed this and there’s no need for further analysis/examination then many thanks… DUDE!

  2. Jerry

    Well well…..just read cuts to be anounced by California “would probably include home healthcare for the elderly and disabled, a nearly $2-billion program that serves 440,000 Californians.”…Should I’ll tell my son, who has disabilities, he should get ready for institutional living so the top 1% can live in luxury while he sleeps and barely lives in huge rooms with 100 or more people with tile floors and walls…but really it will probably the streets instead like we’ve done to the mentally ill…

  3. The Derivative Project

    SIFMA (the securities industry lobbying crew) called the Lincoln Amendment an extraneous “populist” amendment on CNBC this morning.

    Here are the three “populist” amendments that must be in the financial reform bill and here is the one analysis that Congress must order for the American people and for every Senator before any vote is taken on the financial reform bill. Let’s get the facts and hear rational, intelligent debate by Congress.

  4. JC

    I’ve finally reached the conclusion that tracking the rabbit through the anaconda is a waste of time given the present system. With no one in power willing to do anything to upset the status quo to any meaningful degree, anything that is passed will not address the core issues as I see them.

    1: A fractional reserve system that depends on ever-increasing debt in order to have “growth”.

    2: Growth that depends on lots and lots of “defense” spending and war or…

    3: Growth that depends on ever-increasing consumer debt while at the same time keeping wage growth at an absolute minimum if not flat out eliminating all decent paying jobs in favor of off-shoring.

    4: Little technological growth except that technology that keeps the masses happy such as ipods and iphones, not improvements in any energy technology, particularly if that technology upsets the status quo of Big Oil.

    There is more but the above is enough to make the basic point, I think.

    I’m pretty much convinced that the whole system is going down no matter what legislation is passed. It isn’t a matter of if, but only when, it will happen. Constant Warfare, Debt, and Environmental Abuse is clearly not sustainable in the long run, particularly when the Shadow Banking Debt Machine is 10 to 15 times larger than the entire World GDP, and growing even in these tough times.

    I admit that a year of unemployment may have shaded my view, but things really do look a little hopeless at the moment given our do-nothing Congress, Administration, and Media.

  5. RalphR

    A fine post, particularly on issues ignored by the MSM (shadow-banking related measures).

  6. Paul Repstock

    It may not be necessary to “follow the rabbit through the anaconda”. This appears to be a multi level crime, which can best be solved by a process of “elimination”. At this point even eviscerating the anaconda is probably pointless as the evidence has been destroyed.
    To reconstruct the crime scene we merely need to pull the two ends of the anaconda together in which case it quite appropriately resembles the high speed cyclotron at Cern.
    The facts we do know are:
    a)That the “Rabbit” was last seen entering the mouth of the “anaconda” under considerable duress.
    b)That some time latter an unidentifiable ‘vile noxious goo’ was seen leaving the anal are of the anaconda.
    c)That when the authorities questioned ‘vile noxious goo’ in regards to the whereabouts of the missing “Rabbit”, the response was incomprehensible gibberish.
    d)That now the whereabouts of the ‘vile noxious goo’ are also unknown.
    Police have reason to suspect that since we placed the anal part of the anaconda in proximity to it’s mouth, that ‘vile noxious goo’ is again on it’s way through the arcane entrails of said anaconda.
    There is some suspicion that this very circuit may be an accessory to an obstruction of justice and that this may indeed be the motive for this heinous crime.

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