U.S. Financial Reform: The roots of the problem go deeper

Robert Wade, guest blogger

What should we make of the financial reform laid out in the Congress’ bill? The approach is based on the assumption that the financial system is basically sound but needs “more government” in the form of more regulation — as distinct from structural change (for example, to downsize very large banks or to separate deposit-taking banks from investment banks). The Democrat who shepherded the legislation through the Senate, Christopher Dodd, said that improving regulation made more sense than restraining an industry that was critical to the American economy and that faced fierce competition from foreign banks which would not be placed under similar restrictions.

The bill grants more resources and more authority to those charged with supervising the industry, including to the Federal Reserve as the nation’s chief financial regulator; it requires most, but not all, derivatives to be backed by a third-party clearinghouse, so that if either side fails to meet its obligations the clearinghouse steps in to cover them; it creates a consumer protection agency; and it gives the government resolution authority to take over a failing bank and dismantle it in an orderly way.

Even this minimal package faced strong Republican opposition, so one should be grateful that it goes as far as it does. However, the danger of trying to control the banks through regulation (without bigger changes to the structure and scope of banking) is that it ignores the big lesson from the experience of 1970-2010: that the political strength of the US/EU financial sector enabled it to (a) erode banking regulation, and (b) create a parallel non-bank financial sector with almost no regulation.

In the resulting market framework, asymmetric incentives on money managers (to take big gambles confident that gains could be privatized and losses put onto others, as in bonuses based on short-term performance with no penalty for longer-term losses) and herding incentives on money managers (to crowd into investments others have already made, because their performance is judged relative to others’) generated a high and rising level of financial fragility in much of the Atlantic world, and also in developing countries which followed Western advice to open their financial systems.

Financial stability is only likely to be secured by one of two solutions. Either the political strength of the US/EU financial sector has to be curbed, or incentives on money managers have to be more fundamentally changed.

The conservative solution is to curb the political strength of the US/EU financial sector by taking all “very large” or “systemic” financial firms (in the US, with assets over $100 bn) into permanent public ownership (plus independent central bank prudential and macro-supervision). Small banks could be private, provided directors cannot interlock and are jailed if they collude; they would provide useful competition with the state banks.

The more radical solution is to change incentives by ending limited liability in ownership of financial firms. Shareholders would be jointly and severally liable, each up to the limits of their total assets. This was the situation in most rich countries for all sectors before the limited liability acts of the nineteenth century (in the UK, 1855). Today there is a good case for retaining limited liability outside of the financial sector; and a good case for removing it within finance, so that investors in South Sea Bubbles etc. lose their fortunes rather than making the state pay, and are induced to stop their money managers from gambling.

Without either of these changes – public ownership of big banks or removal of limited liability in finance – the existing push to give regulators more money, more information and more power is likely to be subverted by the political strength of the finance industry.  As a taste of what may be to come, when the Senate passed the new finance legislation in mid May Wall Street executives expressed relief, convinced that it would not fundamentally change the way they operate. The bill is 1,300 pages long, with 300 pages devoted to derivatives alone, and it will be a long time before anyone other than Wall Street lawyers understands it.

My guess is that it will take two or three more Lehman or Greece-like crises to generate sufficient political consensus to move in either of these two directions. Don’t hold your breath.

Robert Wade is professor of political economy and development at the London School of Economics.