Business, Content, Domestic, Issue — March 18, 2010 at 7:20 am

Grand Theft Government

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The headlines make it obvious: banks are now earning record profits while the national unemployment rate hovers near ten percent. The clichéd “Wall Street vs. Main Street” dichotomy has become embedded in our political vernacular. Needless to say, the populist sentiment relating to Wall Street is not positive. Populism and sound economics have historically clashed. But the current state of financial regulatory reform—or rather, the
lack thereof—is quickly changing that precedent.

Following the bailout—and subsequent lavish expenditures—of AIG, many feared angry populist sentiments leading to excessive regulation would be the major catalyst. Policymakers and politicians, including President Barack Obama, promised bailouts would end after financial regulation was reformed. Now, supposedly, is the time for the populists to triumph over the big banks, to tame the fat cats of Wall Street, and to end the big bonuses. In retrospect, many financial commentators were concerned that regulatory reform would put a straitjacket on the financial industry by means of taxing bonuses and capping CEO pay, among other measures.

Quite the opposite! No more than a few senators in the banking committee seem willing to support major restrictions on the financial industry. The financial industry is having its way with nearly every feature of the legislation being debated in Congress. How did the populist movement against Wall Street lose its teeth?

At the peak of the financial crisis during the early months of the Obama administration, it seemed as if the populist backlash against Wall Street would translate to radical reforms in the financial sector. Instead, the banking and financial sectors have scaled up their lobbying efforts and successfully pushed back against controversial elements of the regulatory legislation in Congress.

Regulatory reform will have to be more comprehensive if there is to be any substantial progress in preventing future financial crises. In hindsight, the regulatory framework that got the U.S. into this ongoing crisis was filled with numerous holes. Capital requirements were too low while institutions’ activities and financial products lacked any form of transparency. Regulators lacked the necessary tools to allow large, complex banking and financial institutions to fail in an orderly manner, giving rise to the “Too Big to Fail” syndrome and an oversized banking system. Inadequate execution of consumer protection provisions and a flawed incentive structure for financial firms only added to the mess.

Liberals, conservatives, populists, and academics all seem to agree that financial institutions were under-capitalized heading into the crisis. Evidently, many of the major banks in the country lacked the necessary capital buffer to protect against loan losses during the economic downturn. Yet there does not appear to be any method for determining the level to which standard capital requirements should be raised. Some academics have argued for tripling capital requirements, closer to levels banks held prior to the creation of a lender of last resort. As it stands now, the newly set capital requirements come nowhere near those levels. In fact, capital requirements would be raised not even to the levels Lehman Brothers held prior to its collapse.

Other experts claim that simply raising capital requirements to high levels does not seem politically practical. They say it is inevitable for the financial sector to eventually succeed in lobbying for the regulatory authorities to relax capital requirements, and that we will ultimately return to the initial capital requirements just before another crisis strikes. Instead, they have suggested that banks hold a significant amount of capital in convertible bonds, which will allow for the conversion of debt into equity. If a bank comes under stress and poses systemic risk, much of their debt could be converted into equity, thereby reducing the firm’s total liabilities. Yet, as Columbia University Assistant Professor of economics Jón Steinsson pointed out, “Some of these [distressed] banks had contingent capital but they did not convert the debt into equity; they thought the debtholders would be angry. The key is you should not let the firm decide; the government should have the ability to convert capital.”

To some extent, the proposals to increase capital requirements and issuance of convertible debt have been included in House and Senate bills, but the legislation falls short of what most experts would like to see.
Signs of consensus between Democrats and Republicans quickly began to fade once the complexity of creating an effective resolution authority became apparent. The proposed resolution would give regulatory authorities the power to seize and allow a large, complex financial institution to fail in an orderly manner, preventing future financial crises. Currently, if a large financial firm falls into distress, the authority can either allow the firm to fail or bail the firm out by injecting the necessary capital. The former option was tried with Lehman Brothers, but it created chaos in financial markets and large social costs for the greater economy.

The latter option was tried with AIG and the populist uproar towards that bailout has been well-documented. An already established resolution authority with standard protocols on how to behave in these situations would help sidestep the inefficient and disorderly features of the bankruptcy process with respect to financial institutions while avoiding the issues of moral hazard associated with bailouts. The Treasury’s current plan would give the government, specifically the FDIC and the Treasury itself, the ability to seize a large, failing, non-bank institution immediately and put it through a resolution process. However, the Senate Republicans have argued that if the government were to seize a failing non-bank institution, it should have to go through more rigorous checks and approvals beforehand. The trouble is that the Senate Republicans’ plan would make the government resolution procedure more susceptible to creating complications while regulators are trying to wind down an institution. When responding to an emergency situation, approval processes and committee meetings are counterproductive to effectively resolving the problem at hand. Yet surprisingly, the Republicans’ proposal on resolution authority will likely be in the Senate bill.

Ricardo Reis, a Columbia University professor of economics, noted, “Resolution procedures need to be developed in greater depth. The current legislation seems very vague about how to resolve a large, interconnected financial institution.” Much of what led to the aftershocks when Lehman Brothers failed was that the firm held much of its assets in other countries, operating under different legal frameworks. It appears that no one in Congress has thought about the complications that cross-border banks would create. Some have thrown around the idea that these highly interconnected institutions should have living wills—what some call shelf-bankruptcy plans—which are updated on a regular basis in order for the resolution process to go as smoothly as possible. Steinsson threw his support behind the idea of contingency plans, stating that they would serve as “insurance that the government will have at least a minimum amount of information” during a government-controlled resolution. Unfortunately, there have been very few specifics with respect to living wills and by no means will it clear up the problems associated with a government-structured resolution procedure. While the Senate supports the need for a resolution authority, it seems as though no one realizes that a half-baked resolution procedure would not be enough to solve the too-big-to-fail problem.

While the efforts in Congress to reform the financial regulatory framework have been disappointing, the House of Representatives did pass a bill a few months ago that includes the creation of a Consumer Financial Protection Agency. Regrettably, the likelihood of a CFPA being included in the final bill seems low unless Senator Christopher Dodd (D-Conn.), Chairman of the Senate Banking Committee, changes his tone. Republicans on the Senate Banking Committee are already not in favor of the creation of a new regulatory agency and Senator Dodd appears willing to compromise on this feature of regulatory reform. Instead, he argues for greater enhancement of consumer protection divisions under existing regulatory bodies. The issue here is whether consumer protection should be separated from bank regulation. Some might see this task as nothing more than rearranging responsibilities, but consumer protection and bank regulation are two distinct and specialized areas. “Consumer protection in finance requires a level of expertise much higher than what is needed for basic consumer protection,” said Reis. “For effective regulation in finance, you need smart people; financial products are not like toys; you don’t need the best chemists to test out whether a toy is defective.” For a regulatory body to maintain focus on two distinct areas of regulation seems no less than impossible.

Looking back on this past crisis, it is likely that the lack of consumer protection created a situation in which financial innovation could get out of hand so easily. The creation of the CFPA would allow regulators to get ahead of the curve on new financial products without clamping down on financial innovation altogether. Including the CFPA in the bill makes political sense since it sends the message to the public that Congress is serious about confronting the abuses of the financial industry. Hence, it seems baffling that Senate Democrats and Republicans have not embraced the idea. The only reasonable explanation is that the interest groups representing the financial industry are playing a major role in this debate, thereby demonstrating, yet again, the underwhelming effect of populism on the debate.

Since Obama’s election, the populist sentiment against the bailouts and what is seen as the excesses of the financial sector has not materialized into any meaningful legislation in Congress. In early 2010, however, the tone of the administration changed strikingly. President Obama announced in January that he would like Congress to include the Volcker Rule, which would prevent banks from engaging in other speculative activities beyond traditional commercial banking responsibilities.

The centerpiece to the Volcker Rule is the reinstitution of the Glass-Steagall Act, in spirit. Glass-Steagall was enacted in 1933 in order to separate commercial banking, which involves taking deposits and subsequently loaning them out, from other banking activities, widely considered to be more risky, relating to capital markets. While its measures faded away as commercial banks found ways to engage in off-balance sheet and speculative activities, Glass-Steagall was only officially repealed via the Gramm-Leach-Bliley Act in 1999. The repeal of the act removed all boundaries between commercial banking and other financial activities while allowing commercial banks to acquire non-bank financial institutions. Some saw its repeal as an opportunity to increase the productivity of the financial industry, but as Reis states, “We have to look at the effects of the repeal of Glass-Steagall. The financial industry did not become more productive. There were not many synergies made in this past period.” The repeal of Glass-Steagall likely brought more risk to the system rather than less.

Commercial banking is largely considered a necessary component of the economy and worthy of public support in the form of a lender of last resort. Thus, the public provides a subsidy for banks to manage the payments system, take in deposits, and loan them out to worthy borrowers. Following Gramm-Leach-Bliley, bank holding companies could engage in more speculative activities while still gaining access to this safety net. Does this not imply that the public is subsidizing speculative activities distinctly different from commercial banking? Thus, the supporters of the Volcker Rule argue for restoring the boundaries between commercial banking and more speculative activities. Clearly, there are complications with regard to specifics on how to re-create these boundaries when much of Glass-Steagall could have been easily bypassed under current conditions. Nevertheless, it is hard not to see both the merit and populist appeal in this proposal.
Considering how many transformative proposals have been pushed aside, how exactly did the populist movement against Wall Street become defanged in little more than a year after the bailouts and the peak of the financial crisis?

Let us begin with Dodd, the Chairman of the Senate Banking Committee. His ties with the financial industry go back a long way—and for good reason. Many of his constituents in Connecticut work in the financial sector. In addition, Senator Dodd is retiring this year; this bill is likely to be his last hurrah. At the end of Paul Volcker’s testimony, Senator Dodd essentially admitted that, in his view, bipartisanship was more important than solving the problem: “I don’t want to go to the floor of the United States Senate begging for a 60th vote.” Evidently, he would rather stroke his ego with a bipartisan bill that minimally reforms the system than fight for a bill that would bring significant change and reform.

Consider, too, Senator Richard Shelby (R-Ala.), the Ranking Member of the Senate Banking Committee, who was a thorn in the side of Wall Street when the legislation for the Troubled Asset Relief Program was going through Congress. However, 2010 has a different priority: getting re-elected.

All of a sudden, he becomes a friend to the financial, real estate, and insurance sectors, all which are now helping fund his campaign. If the two leading members of the Senate Banking Committee are not committed to reforming the system, what hope is there for substantial change to the regulatory framework?
The financial industry’s lobbying efforts and contributions to Senators’ campaigns should not come as a shock to anyone. What is truly remarkable is that few, if any, interest groups have lobbied on the side of more aggressive regulation. In view of the scope and magnitude of the financial crisis, one would think that an interest group would lobby forcefully for stronger regulation of the financial sector. Evidently, no interest group has filled the role of counteracting the efforts of the financial industry to thwart significant regulatory reform.

No level-headed individual wants angry populism to determine legislation, but to see public sentiment and any serious reform effort overrun by corporate interests is a sign that something is seriously wrong. Many often cite regulatory capture as a deep-rooted problem because the SEC and other financial regulatory authorities are filled with former leaders of financial firms who serve the interests of the financial industry over the interests of the public. What we have here is Congressional capture: members of Congress have been captured by the interests of the banking and financial sectors.

The Democrats missed a clear opportunity to take a more aggressive stance on reforming the regulatory framework. The regulatory reform legislation in Congress could have set forth sound policy for the long-term while still yielding great political profit for representatives and senators from both parties. Disappointingly, reform will almost certainly fall short of what is needed and generate little political return for the Democrats. The final bill will have some benefits: it will raise capital and liquidity requirements, mandate banks to hold easily convertible debt to buffer against times of financial duress, and enforce clearance from central counterparties for derivative transactions in order to assure a safe trading environment. In light of all of the sound reforms that potentially could have been enacted based on public sentiment but ultimately were not, though, America let a good crisis go to waste.

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