What’s Missing in the Financial Rules Bill
By THE EDITORS
Win McNamee/Getty Images Soon after he took office, President Obama gave a speech at the White House calling for regulation of the financial industry. With him, in February 2009, are Barney Frank, Christopher Dodd and Timothy Geithner. So far Republican support is hard to come by, and, on the other side, some Democrats say the bill is not strong enough. What is wrong with the bill, from both perspectives? Are there ways to improve it?
- Peter J. Wallison, American Enterprise Institute and ex-Treasury counsel
- Simon Johnson, M.I.T. professor and co-author of “13 Bankers”
- Tyler Cowen, economist, George Mason University
- Mark Thoma, economist, University of Oregon
You Can’t Ignore the Marketplace
Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute. He was general counsel of the Treasury and White House counsel in the Reagan administration.What’s missing from the Dodd financial regulation bill is any recognition that there is a competitive market out there that can be distorted or destroyed. The bill authorizes the Fed to regulate all “systemically important” nonbank financial institutions, with the power to control the capital, liquidity and permissible activities of the country’s largest securities firms, insurance companies, bank holding companies, hedge funds, finance companies and others.
This bill was designed by people who know or care little about how competitive markets function.
If it increases the capital requirements for, say, hedge funds, it will affect their ability to compete with securities firms or bank holding companies. If an insurance company wants to enter the business of insuring municipal securities, it will be fought by bank holding companies, which already do this business. In other words, competitive issues will be fought out at the Fed or in Congress instead of the marketplace.
Finally, and perhaps most important, the bill would regulate the largest financial institutions because, in theory, their failure could trigger a systemic breakdown. This means they are, by definition, too big to fail. All these institutions will thus have significant advantages over their smaller competitors, especially in obtaining credit.
Because they will be seen as less risky, they will have access to more credit at lower cost. They will also have advantages in selling their products. Imagine an insurance company being able to tell its potential customers that, because it is regulated by the Fed and too big to fail, the policies it offers are safer than those of its smaller competitors.
This bill could only have been designed by people who know or care little about how competitive markets function.
Senator Dodd’s financial reform bill is missing a huge piece of the puzzle. The Obama administration proposed in January to cap the size of our biggest banks going forward, so they cannot pose an even larger threat to the economy than that which we faced in September 2008.
This was a good idea, but it should have gone further. Why would anyone think that today’s size of banks is the right place to stop? After all, it is the banks at their current size who brought us such disaster. And the largest six banks have only become bigger since the crisis — actually, as a direct result of the way the Bush and Obama administrations handled the bailout.
But the most striking fact is that this part of the Volcker Rules has completely failed to make it into the Dodd bill. There is a provision in the bill that regulators can break up large banks but only “as a last resort.” This is very weak and essentially meaningless in today’s context where big banks have great political power.
Because they will be seen as less risky, they will have access to more credit at lower cost. They will also have advantages in selling their products. Imagine an insurance company being able to tell its potential customers that, because it is regulated by the Fed and too big to fail, the policies it offers are safer than those of its smaller competitors.
This bill could only have been designed by people who know or care little about how competitive markets function.
A Tougher Cap on Size
Simon Johnson, a professor at the M.I.T. Sloan School of Management and a senior fellow at the Peterson Institute for International Economics, is the co-author of “13 Bankers: The Wall Street Takeover and The Next Financial Meltdown.”Senator Dodd’s financial reform bill is missing a huge piece of the puzzle. The Obama administration proposed in January to cap the size of our biggest banks going forward, so they cannot pose an even larger threat to the economy than that which we faced in September 2008.
This was a good idea, but it should have gone further. Why would anyone think that today’s size of banks is the right place to stop? After all, it is the banks at their current size who brought us such disaster. And the largest six banks have only become bigger since the crisis — actually, as a direct result of the way the Bush and Obama administrations handled the bailout.
But the most striking fact is that this part of the Volcker Rules has completely failed to make it into the Dodd bill. There is a provision in the bill that regulators can break up large banks but only “as a last resort.” This is very weak and essentially meaningless in today’s context where big banks have great political power.
The amendment proposed by Representative Paul Kanjorski to the House bill was a definite improvement — putting more power in the hands of regulators and also more pressure on them to act preemptively on megabanks that pose risks to the system. But events have moved on considerably since that time — as seen most dramatically by the Securities and Exchange Commission charges against Goldman Sachs last week.
Two months ago, Senator Ted Kaufman was pushing the frontier with tough rhetoric about fraud at the heart of Wall Street. Now his views are completely mainstream. And Senator Kaufman insists, for example, in a speech on Monday that (among many other things) our biggest banks need to be broken up — there is simply no other way to make the financial system significantly safer.
Senator Sherrod Brown will almost certainly have an opportunity to introduce an amendment that would implement a hard size cap on big banks. For all our futures, it is of the highest importance that this amendment succeeds.
The main thing missing from the current bill being proposed by Senator Christopher Dodd — or indeed any of the relevant alternatives — is the idea of a better, more intelligent and more accountable Congress.
Plenty of blame has been levied at the Fed, the regulatory agencies and, of course, the banks themselves. But political scientists sometimes refer to Congress as “the keystone of the Washington establishment” and for good reason. Congress oversees the budget of just about everyone else and sets the standards for their performance. It can be said that each Congress gets the regulatory regime it deserves.
Let’s consider an example of why there is no “once and for all” regulatory solution and why regulatory discretion cannot be avoided. Many commentators criticize the Dodd bill for failing to sufficiently tighten restrictions on bank leverage. That point is well-taken, but just passing restrictions on leverage — and making no further changes — probably won’t have the intended effect. The more binding the leverage restrictions, the more banks and other intermediaries will, sooner or later, recreate implicit leverage off the balance sheet.
Two months ago, Senator Ted Kaufman was pushing the frontier with tough rhetoric about fraud at the heart of Wall Street. Now his views are completely mainstream. And Senator Kaufman insists, for example, in a speech on Monday that (among many other things) our biggest banks need to be broken up — there is simply no other way to make the financial system significantly safer.
Senator Sherrod Brown will almost certainly have an opportunity to introduce an amendment that would implement a hard size cap on big banks. For all our futures, it is of the highest importance that this amendment succeeds.
Congress Is the Problem
Tyler Cowen is a professor of economics at George Mason University. His blog, Marginal Revolution, covers economic affairs.The main thing missing from the current bill being proposed by Senator Christopher Dodd — or indeed any of the relevant alternatives — is the idea of a better, more intelligent and more accountable Congress.
Bank regulation depends on the quality of the bureaucracy and the periodic attention of a responsible legislature.
Let’s consider an example of why there is no “once and for all” regulatory solution and why regulatory discretion cannot be avoided. Many commentators criticize the Dodd bill for failing to sufficiently tighten restrictions on bank leverage. That point is well-taken, but just passing restrictions on leverage — and making no further changes — probably won’t have the intended effect. The more binding the leverage restrictions, the more banks and other intermediaries will, sooner or later, recreate implicit leverage off the balance sheet.
It’s fine to call for maximum transparency, but mostly that’s just wishing for a different world. Activities off the balance sheet are off the balance sheet for a reason and it is hard to squeeze many of them into traditional accounting conventions. Nor should we try to ban off-balance sheet banking, as it would happen somewhere else around the globe or in some other part of the financial sector. Indeed many of these off-balance transactions limit rather than raise risk.
The upshot is that bank regulation is a tough slog: it depends on the quality of the bureaucracy and the periodic attention of a somewhat responsible Legislature. It is like a chess game whereby the private sector eventually finds a way around most of the binding regulations.
In the current debate, there’s far too much attention paid to how we are reshuffling the regulatory boxes and what restrictions we are putting down on paper. It’s the daily reality of regulation that matters and right now the U.S. Congress simply isn’t up to the job.
While we should certainly do our best to prevent bubbles through legislative and regulatory changes, and to prevent other problems like fraud, legislative and regulatory remedies can never ensure that the financial sector will be free of bubbles in the future. Thus, it’s important for financial reform legislation to limit the damage that bubbles can do.
An important factor determining the amount of damage a bubble can do is the amount of leverage in the financial system. The more leverage there is, the bigger the crash. For this reason, limits on leverage are essential.
Senator Dodd’s proposal does allow regulators to set limits on leverage, but that is not enough. This crisis demonstrates that trusting the judgment of regulators who are subject to ideological and regulatory capture can lead to insufficient oversight. We need strict upper bounds on leverage — 15 to 1 for example — limits that are independent of the regulators put in charge under any particular administration
The upshot is that bank regulation is a tough slog: it depends on the quality of the bureaucracy and the periodic attention of a somewhat responsible Legislature. It is like a chess game whereby the private sector eventually finds a way around most of the binding regulations.
In the current debate, there’s far too much attention paid to how we are reshuffling the regulatory boxes and what restrictions we are putting down on paper. It’s the daily reality of regulation that matters and right now the U.S. Congress simply isn’t up to the job.
Controlling Bubble Damage
Mark Thoma is an economics professor at the University of Oregon and blogs at Economist’s View.While we should certainly do our best to prevent bubbles through legislative and regulatory changes, and to prevent other problems like fraud, legislative and regulatory remedies can never ensure that the financial sector will be free of bubbles in the future. Thus, it’s important for financial reform legislation to limit the damage that bubbles can do.
We need leverage limits that are independent of regulators put in charge under an administration.
Senator Dodd’s proposal does allow regulators to set limits on leverage, but that is not enough. This crisis demonstrates that trusting the judgment of regulators who are subject to ideological and regulatory capture can lead to insufficient oversight. We need strict upper bounds on leverage — 15 to 1 for example — limits that are independent of the regulators put in charge under any particular administration
The other place that the legislation could do better is in limiting the size of banks. There is no convincing evidence that banks need to be as large as allowed under the Dodd legislation for the financial system to function efficiently. However, limits on bank size may not protect the financial system from a meltdown. If small banks are exposed to common risks or sufficiently interconnected, then many small banks could fail simultaneously and mimic the failure of a large bank, something that has happened in the past.
Reducing size is no guarantee of safety. But limiting bank size does limit the political power of financial institutions. Imposing regulations such as strict limits on leverage is much more difficult when banks are politically powerful, and that alone is sufficient reason to enact strict limits on bank size.
Reducing size is no guarantee of safety. But limiting bank size does limit the political power of financial institutions. Imposing regulations such as strict limits on leverage is much more difficult when banks are politically powerful, and that alone is sufficient reason to enact strict limits on bank size.
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