US Financial Regulations: Plugging holes in a faulty dam

Jeff Madrick

Paul Volcker says the financial reregulation bill passed to much hoopla by Congress in mid-July deserves only a grade of B.  Sheila Bair, head of the Federal Deposit Insurance Corporation, says the Basel committee of the Bank for International Settlements is already backing off stern capital requirements for banks that the bill was supposed to establish. Michael Mandel, the former chief economist of Business Week, says he cannot even tell you what the financial regulation bill is trying to accomplish.

To most people, the new financial reregulation package must look like the work of a bunch of Congressmen, along with the President’s economic team, plugging holes in a dam.   The Obama Treasury got the nation off on the wrong track when it issued its June 2009 white paper. It basically listed a series of problems that had to be dealt with. Does anyone have a sense which are the biggest holes, how many there are, and whether we’ve really plugged them?   Or why there were holes in the first place?

In fact, the problem with the bill is that it has no clear, focused objective. It accepted the ambiguous notion that there were many regulatory failures—the holes in the dam– and seemed intent on quickly if only temporarily fixing them.    There was no true theory of why the regulators failed, except the broad claim that now financial institutions were so big, any one that failed could bring down the system. This was a reflexive response to the damage done when Lehman Brothers was allowed to go bankrupt in September, 2008.

The conventional wisdom has been that everything and anything went wrong.  Many said some version of,  “every once in a while, these things just happen.” This was a useful excuse for people like Bob Rubin, the high-up executive at Citigroup and former Treasury secretary. If everyone was to blame, then no one was to blame. A lot of journalists and commentators bought into this. It was a “cluster f***,” as one kept repeating to me.   In such a mushy intellectual environment, the bill didn’t categorize the problems or prioritize them.

One doesn’t have to have an airtight explanation of the crisis to come up with a better way to understand the regulatory and market failures.

First, there was a large category of conventional market failures tolerated by the regulators, including the Federal Reserve, the Securities and Exchange Commission, the FDIC, the Commodities Futures Trading Commission, and the Clinton and Bush Treasuries.

These included the lack of transparency in the derivatives markets, where prices were set in obscurity on trillions of dollars of transactions. Market theory calls for clear and open pricing information. It includes the conflicts of interest of the credit ratings agencies, which were paid by the issuers seeking high ratings.  This is bound to lead to market failure. There are also the absurd compensation practices of Wall Street, which largely protected the traders and other decision-makers from the longer-term risks the stockholders were taking.

Most economists would agree that markets cannot work under these conditions.  Measures to change these had to be taken.  In the case of derivatives, they partly were, placing trading in clearing houses, for example.  But ample room for dubious exceptions was left.

A second major market failure is less widely agreed to by mainstream economists. It is herd behavior—the profound inefficiency of price setting in financial markets.   People follow the pack, believe the absurd, take ridiculous risks for near-term profits. Systemic risk, as it became known, is really about everyone doing the same thing.  The only way to deal with this is higher capital requirements, and low leverage tolerance.  Or forbidding speculative practices altogether, like prohibiting banks that take deposits for trading for their own account or buying and selling derivatives.

A third area is outright fraud. Are the nation’s laws truly adequate to control conscious deceit on Wall Street?  The SEC is now taking some action, but attention to this could have been acknowledged as necessary by the Obama Treasury department.

Had the administration made a case along these lines, it could have more firmly presented its arguments to the public and better staved off the lobbyists. As it is, the regulations that have been proposed are relatively weak. There are exceptions to derivatives trading, as noted.  Not enough has been done about the credit ratings agencies. Almost nothing is done about compensation.

As for capital requirement, a new body composed of the Fed, SEC, FDIC, Treasury and a few others will determine who is too big to fail and impose higher capital requirements.  But why will they act, and will they act in time?

Far better to raise capital requirements now for all major financial institutions, but this has been thrown to Basel, which is already backing off. Global regulations make sense, but this most important of changes will be badly diluted.  And of course, commercial banks which take deposits have been only slightly restrained from risky practices by the so-called Volcker rule.

In the end, all will depend on the future rules and oversight of the regulators—basically the same ones who already failed us. There is not very much to celebrate in the new legislation.

4 Responses to “US Financial Regulations: Plugging holes in a faulty dam”

  1. Ralph Sato says:

    Jeff Madrick raises some important points in this article on the financial regulation reform bill that was recently passed by Congress. His comment that the reform bill has “no clear focused objective” and that it looks like the work of a team trying to plug holes in a dam is a poignant characterization. I would like to direct your attention to a great article by John R. Talbott, “the Failure of Financial Reform, Itemized”, which gives a detailed explanation of 47 items that should have been addressed but was ignored in the reform bill. Talbott, formerly of Goldman Sachs, is the successful author of numerous books on economics including his 2003 book “the Coming Crash of the Housing Market” and “Obamanomics” which was published in 2008. Talbott’s article appeared on June 30, 2010 on the Huffington Post blog. The Huffington Post is as the name Arianna Huffington implies, primarily a politically oriented blog of news stories but I found that it has had some of the best most informative articles on the financial crash and crisis, because of its fearless attitude of inviting some of the best commentators such as Elizabeth Warren, Dylan Ratigan, and Simon Johnson among others.

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