If you listen to the criticism from the right and from the left, from pro-regulation and anti-regulation pundits, you can understand the political constraints which produced the white paper which the President unveiled yesterday. Given those constraints, I consider the white paper a good effort.
My initial reaction, therefore, was largely positive. However, upon further reflection, it is clear this is a political document more than a regulatory one. The white paper is a govern by consensus product about which I have grave reservations. There is much to like about the white paper, but also much to question. As a result, I see no need to rush ahead and enact sweeping legislation and reform before the full measure of the financial crisis has been felt and the implications of regulatory lapses is known.
Propaganda campaign is coming
An orchestrated media blitz is now under way. We have Summers and Geithner’s Op-Ed in the Washington Post Monday. Christina Romer on Bloomberg today. The President giving his speech, Austan Goolsbee was on CNBC talking this thing up and Sheila Bair released a statement of support. Obama’s whole financial team is out making the rounds in support of this legislation.
How are people reacting to the plan? Banks seem happy. Arthur Levitt, a consultant to Carlyle and Goldman Sachs, is happy. Ron Paul and most economists – not so much – but for very different reasons. This should tell you that the legislation is fairly bank-friendly. But the unhappy parties make clear that there are political constraints.
There is no need to rush
During the Great Depression, most of the important pieces of legislation were enacted after the economy had already bottomed. The economy started down in 1929, bottoming in 1933. The reforms were enacted starting in 1933. The Glass-Steagall Act of 1933 was the comprehensive piece of regulation reform. It also established the FDIC. The Securities Exchange Act establishing the SEC was enacted in 1934. Fannie Mae was founded even later in 1938.
Today, the knock-on effects of the financial crisis are still being felt. Just yesterday, California was rejected in its request for a U.S. government bailout. Today, the large U.S. retailer Eddie Bauer was declared bankrupt. The market for municipal bonds is still impaired because of municipalities deteriorating financial condition. Credit Card delinquencies are hitting a record high. These are just a few of the many events which make clear that we are still in the midst of some horrific economic turmoil. Enacting sweeping legislation in that environment would be tragically premature.
Having said that upfront, I am going to run through some of the more important bits in the white paper with you.
What’s wrong with this proposal
1. Financial Services Oversight Council. This is the new day-to-day super-regulator. Really it is more of a gathering of regulators to hash out turf wars and co-ordinate policy. I am hearing that this structure was implemented because there was a lot of pushback from lawmakers about abolishing regulatory agencies and consolidating power in the hands of the Federal Reserve. The Treasury leads this council, putting an unelected official in the executive branch in control of the most powerful day-to-day regulatory structure. I do not like this at all. Better would be an oversight council headed by an official appointed by members of Congress so that more elected officials have a role in those decisions.
2. Tier 1 FHCs. (Tier 1 Financial Holding Companies) This is the designation used for too big to fail financial institutions like JPMorgan Chase and Citigroup. Under the proposed regulations, there will be a penalty for being too big to fail: these organizations must have more capital and are subject to more oversight than other companies. This is great in theory. However, in practice right now it will mean less lending – one reason there is no need to rush to institute reforms prematurely. In fact, just today a number of Tier 1 FHCs repaid $68 billion in TARP money i.e. they reduced their capital base by $68 billion. Higher capital requirements/less capital equal less lending.
3. Systemic Risk Regulator. (SiRR) As expected, the Federal Reserve is going to be the SiRR. This is the same organization that brought us 1% rates in 2003 and 0% rates this year. The Federal Reserve is also the same institution which refused to crack down on loose lending standards during the height of the housing bubble. Under no circumstances should the Federal Reserve’s lapses be rewarded with the role as the SiRR.
4. Executive Compensation. As far as I am aware, there is nothing to restrict executive compensation in the financial services sector in this proposal. And if you haven’t heard already, mega-bonuses are already making a comeback. Clearly this is an area that must be addressed in any reform package. You cannot get the right behaviors if you do not align incentives to those behaviors.
5. OTC Derivatives. Larry Summers was not a big fan of regulation on this score when he was in the Clinton Administration. This time, the proposal suggests ‘clearinghouses’ for these derivatives. What does ‘clearinghouse’ mean? To me, it doesn’t mean anything. George Soros wants to ban OTC derivatives outright like CDS contracts. At a minimum, we need to see these contracts traded on exchanges like the CME or CBOE in standardized forms with adequate collateral from counterparties. Forget about ‘clearinghouses.’ [Update: the reason I stress the term 'clearinghouse has to do with Obama Administration opposition to making OTC derivatives exchange-traded. A clearinghouse is not enough. An exchange is more than a clearinghouse and involves standardization of contracts and regulation.]
6. Office of National Insurance. While I like the fact that we are seeing a move to comprehensive regulation of insurance instead of the present state-by-state system, this proposal should be a non-starter because, yet again, the power lies at Treasury. Why is Treasury a good place for an Office of National Insurance other than the desire to increase power in the executive branch? Moreover, this does not remove the balkanized regulatory framework in insurance. I see this as an inadequate half-measure.
1. Determine Future role of Frannie Mac. This is a complete punt. There is no information here. It’s probably for the best as it is too early to make a call one way or another.
2. Enhance International Coordination. This is another punt. At least, we see an effort in the right direction. In my view, this will be an important area to flesh out with other regulators as the world of finance is global and global regulatory controls are needed.
3. Consumer Finance Protection Agency. The proof here is in the pudding. But, clearly abuses in the last decade were extreme. How this agency works in concert with other regulators is unclear. As they have zero authority as the bank regulator, I do not think putting them in a separate agency is going to work.
4. Credit Rating Agencies. There is a proposal to tighten oversight over the rating agencies in this white paper. This proposal has no meat on the bones so the devil will be in the details.
What’s right with this proposal
1. Hedge funds. Hedge funds and other large pools of capital must now be regulated under this proposal. In all likelihood, the proposed changes will end the shadow banking system as we know it, with hedge funds being completely outside the regulatory structure.
2. Money Market Funds. The SEC is going to strengthen the rules around MMFs in order to prevent runs and to mandate MMFs always have access to emergency liquidity facilities.
As you can see from the number of items in each category, there is probably more to dislike than to like. I do think this is a good effort but it is not nearly concrete enough to be the basis for legislation. Moreover, it is much to soon to start making comprehensive reforms. We are still in crisis mode. On the whole, it would be a deep disappointment to see any legislation resulting from this white paper, particularly now as we are in crisis. However, by this time next year, things should be clearer and having this white paper in hand will be to everyone’s benefit.
One last thought: Barack Obama does a very good job of striking the right tone and saying the right things, but I am suspicious about his commitment to true reform. This document is not the product of someone who wants reform, but of someone looking to strike a middle ground in a political game.
Below is the audio of comments I made regarding the ‘political nature’ of the agenda on BBC Radio Five Live. The clip also talks about how this is likely to affect Alistair Darling and Labour’s need to reform in the U.K.