Financial Reform: Will Congress Take The Side Of Corporations Or The Public?

The ability of congress to pass financial reform may be no match for the ability of large financial corporations to block it. Political writer Matt Taibbi describes the efforts of Goldman Sachs to shamelessly lobby congressmen to protect the interests of the financial giant. See the following from Economist's View to learn more.

I am not as negative toward naked short-selling as Matt Taibbi (feel free to convince me I'm wrong), but his insights into the lobbying effort against financial reform are useful, and I share his concerns about the distortions (e.g. regulatory capture) this brings to the reform process:

An Inside Look at How Goldman Sachs Lobbies the Senate, by Matt Taibbi: ...Later on this week I have a story coming out in Rolling Stone that looks at the history of the Bear Stearns and Lehman Brothers collapses. The story ends up being more about naked short-selling and the role it played in those incidents than I had originally planned..., but it turns out that there’s no way to talk about Bear and Lehman without going into the weeds of naked short-selling...

It’s the conspicuousness ... that is the issue here, and the degree to which the SEC and the other financial regulators have proven themselves completely incapable of addressing the issue seriously, constantly giving in to the demands of the major banks to pare back (or shelf altogether) planned regulatory actions. There probably isn’t a better example of “regulatory capture” ... than this issue.

In that vein, starting tomorrow, the SEC is holding a public “round table” on the naked short-selling issue. What’s interesting about this round table is that virtually none of the invited speakers represent shareholders or companies that might be targets of naked short-selling, or indeed any activists of any kind in favor of tougher rules against the practice. Instead, all of the invitees are either banks, financial firms, or companies that sell stuff to the first two groups.

In particular, there are very few panelists — in fact only one, from what I understand — who are in favor of a simple reform called “pre-borrowing.” Pre-borrowing is what it sounds like; it forces short-sellers to actually possess shares before they sell them.

It’s been proven to work, as last summer the SEC, concerned about predatory naked short-selling of big companies in the wake of the Bear Stearns wipeout, instituted a temporary pre-borrow requirement...

The lack of pre-borrow voices invited to this panel is analogous to the Max Baucus health care round table last spring, when no single-payer advocates were invited. So who will get to speak? Two guys from Goldman Sachs, plus reps from Citigroup, Citadel (a hedge fund that has done the occasional short sale, to put it gently), Credit Suisse, NYSE Euronext, and so on.

In advance of this panel and in advance of proposed changes to the financial regulatory system, these players have been stepping up their lobbying efforts... Goldman Sachs in particular has been making its presence felt.

Last Friday I got a call from a Senate staffer who said that Goldman had just been in his boss’s office, lobbying against restrictions on naked short-selling. The aide said Goldman had passed out a fact sheet about the issue that was so ridiculous that one of the other staffers immediately thought to send it to me. When I went to actually get the document, though, the aide had had a change of heart.

Which was weird, and I thought the matter had ended there. But the exact same situation then repeated itself with another congressional staffer, who then actually passed me Goldman’s fact sheet.

Now, the mere fact that two different congressional aides were so disgusted by Goldman’s performance that they both called me on the same day — and I don’t have a relationship with either of these people — tells you how nauseated they were.

I would later hear that Senate aides between themselves had discussed Goldman’s lobbying efforts and concluded that it was one of the most shameless performances they’d ever seen from any group of lobbyists, and that the “fact sheet” ... was, to quote one person familiar with the situation, “disgraceful” and “hilarious.” ...

This post has been republished from Mark Thoma's blog, Economist's View.

Time Running Out On Financial Reform

Both Obama and Barney Frank want to see financial regulation passed by the end of the year, but the progress so far is not encouraging. Each day that meaningful reform is delayed makes success tougher, as public interest of the issue continues to fade. See the following discussion from Mark Thoma's blog.

Simon Johnson and James Qwak wonder how much political capital the administration is willing to use to meaningfully reform the financial system:

It's Crunch Time: The Fight to Fix the Financial System Comes Down to This, by Simon Johnson and James Kwak, Commentary, Washington Post: The next couple of months will be crucial in determining the shape of the financial system for decades to come. And so far, the signs are not encouraging.

The Obama administration is trying to refocus our attention on regulation, beginning with the president's speech in New York two weeks ago. ... Barney Frank, chairman of the House Financial Services Committee, says that he still plans to pass a regulatory reform bill before the end of the year.

But in a clear indication of trouble ahead, Frank signaled his intention last week to scale back the proposed Consumer Financial Protection Agency, one of the pillars of the administration's reform proposals. ...

We have criticized the administration's reform proposals, in particular for not going far enough to address the problem of financial institutions that are "too big to fail." But we support much of what was in the original package... The question now is how hard Obama and Geithner will fight for it.

Financial regulation, like health care reform, has entered the phase where speeches and proposals matter less than arm-twisting and horse-trading on Capitol Hill. With health care, President Obama attempted to go over the heads of Congress, directly to the American people. With financial regulation, that is no longer an option, given the extent to which it has faded from public consciousness. Instead, the administration is playing on the home turf of the banking industry and its lobbyists. ... Is Obama up for this fight? ...

Elections have consequences, people used to say. This election brought in a popular Democratic president with reasonably large majorities in both houses of Congress. The financial crisis exposed the worst side of the financial services industry to the bright light of day. If we cannot get meaningful financial regulatory reform this year, we can't blame it all on the banking lobby.

The initial bill needs to be as strong as possible, and I agree that the administration needs to do what it can to prevent the bill from being scaled back. However, the initial legislation won't be as strong as I'd like even if the administration does prevail. But I hope we aren't thinking that we'll take one stab at financial reform and then we'll be done with it. Like climate change and health care, it will require a series of bills to achieve effective reform.

This post has been republished from Mark Thoma's blog, Economist's View.

We Need Answers On Financial Reform

Daniel Dicker from The Street says we need more specifics about financial reform. With financial reform seeming to have fallen behind health care as the top priority of the Obama administration, Dicker fears that we may be missing an opportunity to regulate potentially harmful financial instruments. See the following post from The Street for more on this.

In the wake of President Obama's speech Monday, one piece of possible finance reform less explored is with derivatives, including credit default swaps, commodities and other over-the-counter issues. Despite the president's inspired speech preaching responsibility on Wall Street, we really haven't come very far in this area in the year since the demise of Lehman Brothers.

Part of the problem I had with his impassioned speech was with the lack of specifics. Despite being a great supporter of the president and having voted for him, I find many of his speeches great oratory events with little substance contained in them.

In his talk of finance reform, Obama made some vague calls for increased capital requirements for the big banks, a requirement that in and of itself wouldn't have prevented the cataclysm we experienced last year.

As to the most important ideas of transparency in markets, Obama focused on the idea of a "consumer czar" or other advocate in Washington who would somehow prevent the sale of mortgages that people couldn't understand or afford. How this would be done, however, remains a mystery.

But derivatives, which clearly exacerbated the financial downturn last year, were left conspicuously out of the president's speech. This is an interesting omission because they had gotten so much interest in their operation and their reform last year, but now seem to be on a very far back burner and not gaining much attention anymore.

This is a shame because I believe that derivatives, much more than shady mortgage practices, create a far greater threat to our financial health going forward.

What's interesting is that the Bush administration had taken the greatest strides in bringing transparency to this market, and the Obama administration, while having public sentiment and great momentum on their side, has really dropped the ball here and squandered a great opportunity.

It was former Treasury Secretary Henry Paulson who issued the ultimatum for transparency in credit default swaps, requiring a clearinghouse structure for clearing of these instruments. But since President Obama was inaugurated, Treasury Secretary Tim Geithner has done nothing to follow up on these initiatives, essentially leaving the market exactly as it was and leaving us open again for another "AIG(AIG Quote)-like" problem.

To the detriment of our economy, especially consumers, oil and other commodity markets have continued to show increased and unceasing volatility. They are being moved by investment capital, hedge funds, uncontrolled ETFs and just about everything except the fundamentals.

Despite our new president's impressive speeches, absolutely nothing has been proposed or undertaken to get a better handle on the roiling commodity markets.

And those markets are just a microcosm of the rest of the enormous over-the-counter markets of specialized and non-standardized forwards and swaps.

While the CDS market with its $26 trillion notional value has been the most visible of the OTC markets because of the trouble they've caused, other markets traded in the shadows of the investment banks pose as much or more of the same kind of risks in the future. In getting a handle on credit default swaps, a model for dealing with systemic risk in all of the OTC markets might be found.

You won't find enthusiasm from the biggest investment banks like Goldman Sachs(GS Quote), Morgan Stanley(MS Quote), UBS(UBS Quote), JPMorgan Chase(JPM Quote) and others, who derive terrific percentages of their profits from OTC trading for reform in these markets, many of which they created.

And other open exchanges that would benefit from transparency in the trading of CDS issues and other OTC swaps like the Chicago Mercantile Exchange(CME Quote), IntercontinentalExchange(ICE Quote) and the NYSE Euronext(NYX Quote) are less apt to push hard for reform because their biggest potential clients in these new markets are those same investment banks. You can't bite the hand that ultimately feeds you.

Good results from the stimulus package, bank bailouts and Fed guarantees of mortgages that halted the stock market slide and a total seizure of the credit markets have also stemmed the interest of market reform that got us into this mess in the first place.

This is a dangerous, if perfectly understandable reaction. Nobody ever thinks of fixing a hole in the ceiling more desperately than when it's raining. But when the rain stops and water isn't dripping on your head, that hole seems far less important to fix.

And Obama may be even less able to tackle these problems than his predecessor, despite his greater natural ease towards reform. The current administration has taken on quite a few issues at once and while the economy was clearly job one immediately after inauguration, it now feels as if it has taken a back seat to health care reform. One visit to Federal Hall yesterday on Wall Street and one speech, no matter how rousing, can change the amount of political capital that any president has and where he spends it first.

So a year after the fall of Lehman, it seems that we are nowhere closer to reforming or even creating new rules for the markets that were the source of all the difficulties last year -- including credit default swaps, commodities and other OTC markets.

I think we will live to regret having missed this opportunity.

This article has been republished from The Street.

Americans Held Hostage By Large Financial Firms

Dylan Ratigan rants about large financial firms who are holding Americans hostage by being too big to fail, forcing the government to bail them out or suffer tremendous financial damage. These same companies have been spending record amounts to prevent government from doing anything to change this. The following post from The Mess That Greenspan Made, discusses why financial companies are making reform very difficult.

Former CNBC star Dylan Ratigan, who now toils away at MSNBC, had these thoughts to share over at the Huffington Post regarding the state of the U.S. financial system.

Americans Have Been Taken Hostage
The American people have been taken hostage to a broken system. It is a system that remains in place to this day.

A system where bank lobbyists have been spending in record numbers to make sure it stays that way.

A system that corrupts the most basic principles of competition and fair play, principles upon which this country was built.

It is a system that so far has forced the taxpayer to provide the banks with the use of $14 trillion from the Federal Reserve, much of the $7 trillion outstanding at the US Treasury and $2.3 trillion at the FDIC.

A system partially built by the very people who currently advise our President, run our Treasury Department and are charged with its reform.

And most stunningly -- it is a system that no one in our government has yet made any effort to fundamentally change.

That seems to be a common theme today, that is, if you're paying attention to that sort of thing rather than being distracted by where (and with whom) President Obama had lunch today after delivering another inspiring speech, this before a Wall Street crowd on the subject of financial market reform on the anniversary of the collapse of Lehman Brothers.

President Obama noted:

I want everybody here to hear my words. We will not go back to the days of reckless behavior and unchecked excess at the heart of this crisis, where too many were motivated only by the appetite for quick kills and bloated bonuses. Those on Wall Street cannot resume taking risks without regard for consequences, and expect that next time, American taxpayers will be there to break their fall.

So far, the odds of reforming health care seem much better than for Wall Street.

If Washington was really serious about changing the way things work in New York, they ought to just nip that "life settlements securitization" business in the bud right now.

But they won't.

Unlike the health care industry, a group that heavily influences what lawmakers do, the financial industry essentially runs some portions of the government, and that makes change all the more difficult.

Back to Mr. Ratigan, who opines on that same topic:

Like health care, this is a referendum on our government's ability to function on behalf of the American people. Ask yourself how long you are willing to be held hostage? How long will you let our elected officials be the agents of those whose business it is to exploit our government and the American people at any cost?

As hostages -- was there any sum of money we wouldn't have given AIG?

Why did we pay Goldman Sachs and all the other banks 100 cents on the dollar for their contracts with AIG, using taxpayer money, while we forced GM and others to take massive payment cuts?

Why hasn't any of the bonus money paid to the CEOs that built this financial nuclear bomb been clawed back?

And more than anything else -- why does the US Congress refuse to outlaw the most anti-competitive structure known to our economy, one summed up as TOO BIG TOO FAIL?

There's much more to this, including something of a mea culpa from Ratigan for contrary views expressed whle in the employ of CNBC.

It's too bad that the public at large doesn't understand the financial system as well as they do health care or they'd be doing things that would make recent health care town hall meetings look quite tame by comparison.

Today, the mood generally seems to be, "Just keep the stocks in my retirement plan going up, not down, and we'll forget about the whole thing."

This article has been republished from Tim Iacono's blog, The Mess That Greenspan Made.

What's More Important: Finance or Health Care Reform?

Barry Ritholtz, author of Bailout Nation, argues that the Obama Administration is missing a once in a lifetime opportunity by putting financial reform on the back burner. The concern is that the window of opportunity to clean up Wall Street is closing as financial lobbyists dig in and public support wanes. For more on this, see the following post from Economist's View.

Barry Ritholtz says the administration should have pursued financial reform before health care reform:

Tactical Error: Health Care vs Finance Regulatory Reform, by Barry Ritholtz: I believe the brain trust behind the Obama White House has made a huge tactical error.

As Rahm Emmanuel likes to say, one should “never waste a crisis” — and the White House has done just that.

There was a narrow window to effect a full regulatory reform of Wall Street, the Banking Industry and other causes of the collapse. Instead, the White House tacked in a different direction, pursuing health care reform.

This was an enormous miscalculation. ... What we got instead, was the usual lobbying efforts by the finance industry. They own Congress, lock stock and barrel, and they throttled Financial Reform. It did not help that the Obama economic team is filled with defenders of the Status Quo — primarily Summers, but it appears Geithner also — the dynamic duo that fiddled while the economy burned.

Such dithering can be fatal to an administration.

This was a colossal blunder. Passing reform legislation successfully would have fulfilled the campaign promise of “Change;” it would have created legislative momentum. It could have provided a healthy outlet for the Tea Party anger and the raucous Town Hall meetings. It might have even led to a “throw the Bums out” attitude in the mid-term elections, forcing the most radical de-regulators from office.

Also wasted: The enormous anti-Bush attitude throughout the country that swept team Obama into office. He should have been “Hooverized,” and O should have tapped into that same wave to force the greatest set of Wall Street and Banking regulatory reforms seen since the 1930s.

Instead, we have a White House that appears adrift, and the most importantly, may very well have missed the best chance to clean up Wall Street in five generations.

Never waste a crisis, indeed . . .

I also believe that the administration should have moved faster on financial reform, but if the cost is to delay and possible endanger health care reform (lobbying efforts would have been in full force there too), then it's less clear. Would it have been impossible to do both? And where does climate change legislation fit into all of this?

This post has been republished from Mark Thoma's blog, Economist's View.

Is Time Running Out On Financial Reform?

With so many issues on the plate of legislators, is financial reform falling down the list of priorities for lawmakers? Economists Alan Blinder and Mark Thoma express concerns that the window of opportunity for financial reform may be closing. See the following post from Economist's View for more.

Alan Blinder is worried that the will to reform the financial sector is fading:

The Wait for Financial Reform, by Alan S. Blinder, Commentary, NY Times: ...We are barely emerging from the greatest financial crisis since the 1930s. From last September to March, it was downright frightening. Yet by the time Congress left town for its summer recess, financial reform appeared to be losing steam. ... Why is the pulse of reform so faint? I see five main reasons:

IT’S YESTERDAY’S PROBLEM People have an amazing capacity to forget. Our financial system is now functioning much better than it was in March or last fall. ... You can see public attention shifting elsewhere... I want to scream, “Stop!” The financial regulatory system needs fixing, and to accomplish it, Congress will have to hold a lot of feet to a lot of fires. It’s not clear that many members have the stomach for that.

LOST IN THE CROWD The problem of short attention spans has a first cousin: the overcrowded legislative agenda... There is a budget to pass, health insurance to reform, energy to cap and trade, schools to overhaul, two wars to watch over and others to avoid — and more. Amid all of this, the Treasury has sent Congress 16 pieces of financial reform legislation... What are the chances that these 16 bills will surface to the top of the legislative agenda?

THE MOTHER OF ALL LOBBIES Almost everything becomes lobbied to death in Washington. In the case of financial reform, the money at stake is mind-boggling, and one financial industry after another will go to the mat to fight any provision that might hurt it. ...

BUREAUCRATIC INFIGHTING Industry lobbyists are not the only problem. Regulatory deck chairs need to be rearranged, and various government agencies are scrambling to maintain or expand their turfs. ..The bureaucratic turf wars have grown intense...

A LACK OF FOCUS Perhaps worst of all, it’s hard to keep the public engaged in something as complex, arcane and — frankly — as boring as financial regulation. ... Today, the electorate has a vague sense that it has been ripped off and that change is needed. But the sentiment is unfocused and inchoate — with these two exceptions: People clearly want greater consumer protection and restrictions on executive pay.

By no coincidence, those are the two pieces of financial reform that seem most likely to survive the Congressional sausage grinder. Don’t get me wrong; we need both. But the two don’t constitute the entirety of reform, or even its most important parts.

I’d attach greater importance to at least three major Treasury proposals that may wind up on the cutting-room floor:

First, we need a systemic risk monitor or regulator. ... In my last column, I explained ... why the Fed should get the job.

Second, we need a new mechanism to euthanize or rehabilitate giant financial institutions whose failure could threaten the whole system. ...

Third, something serious must be done to tame — though not to destroy — the derivatives markets. ...

And there is a great deal more... So let’s get on with the job...

Here's my view on the tension between imposing regulation before the will to do so fades, and delaying to avoid upsetting already unsettled financial markets and to carefully consider the changes before putting them into place:

While it's possible that regulation will go overboard in response to the crisis, there are powerful interests that will resist regulatory changes that limit their opportunities to make money (and Nobel prize winning economists willing to back them up), so my worry is that regulation will not go far enough, particularly with people ... arguing that we should wait for recovery before making any big regulatory changes to the financial sector. They may be right that now is not the time to change regulations because it could create additional destabilizing uncertainty in financial markets, and that waiting will give us time to see how the crisis plays out and to consider the regulatory moves carefully. But as we wait, passions will fade, defenses will mount, the media will respond to the those opposed to regulation by making it a he said, she said issue that fogs things up and confuses the public as well as politicians, and by the time it is all over there's every chance that legislation will pass that is nothing but a facade with no real teeth that can change the behaviors that go us into this mess.

This post has been republished from Mark Thoma's blog, Economist's View.

Why We Should Regulate Banks Immediately

Despite the banking sector's large role in crashing the economy there are still some who oppose increasing bank regulation. Harvard Economist Kenneth Rogoff, discusses why we need to regulate banks as soon as possible. Mark Thoma summarizes his commentary below.

Kenneth Rogoff warns us not to believe those who argue that the crisis was largely due to government failure, and hence that regulating the financial sector is counterproductive and unnecessary:

Why we need to regulate the banks sooner, not later, by Kenneth Rogoff, Commentary, Financial Times: When in doubt, bail it out,” is the policy mantra ... after the ... collapse of Lehman Brothers. With the global economy tentatively emerging from recession, and investors salivating over the remaining banks’ apparent return to significant profitability, some are beginning to ask: “Did we really need to suffer so much?”

Too many policymakers, investors and economists have concluded that US authorities could have engineered a smooth exit from the bubble economy if only Lehman had been bailed out. Too many now believe that any move towards greater financial regulation should be sharply circumscribed since it was the government that dropped the ball. Stifling financial innovation will only slow growth, with little benefit in terms of stemming future crises...

Certainly the US and global economy were already severely stressed at the time of Lehman’s fall, but better tactical operations by the Federal Reserve and Treasury, especially in backstopping Lehman’s derivative book, might have stemmed the panic. Indeed, with hindsight it is easy to say the authorities should have acted months earlier to force banks to raise more equity capital. The March 2008 collapse of the fifth largest investment bank, Bear Stearns, should have been an indication that urgent action was needed. Fed and Treasury officials argue that before Lehman, stronger measures were politically impossible. There had to be blood on the street to convince Congress. ...

[C]ommon sense dictates the need for stricter controls on short-term borrowing by systemically important institutions, as well as regularly monitored limits on oversized risk positions, taking into account that markets can be highly correlated in a downturn. ... There should also be more international co-ordination of financial supervision, to prevent countries using soft regulation to bid for business and to insulate regulators from political pressures.

...The view that everything would be fine if Hank Paulson, then US Treasury secretary, had simply underwritten a $50bn bail-out of Lehman is dangerously misguided. The financial system still needs fundamental reform...

I think that even if Lehman had been bailed out the economy would still have been bad, just not as bad, so either way there are substantial economic costs and a case for regulation.

This article has been republished from Mark Thoma's blog, Economist's View.

Overleveraged Economy Not To Blame For Financial Crisis

According to MIT economics professor Ricardo Caballero, leverage is not the real problem that led to the financial collapse, but rather excessive concentration of risk. If he is right, could policy makers be chasing the wrong culprit as they create new regulation for the financial system? The following post from Economist's View, discusses this alternative view.

Ricardo Caballero hasn't given up on his argument that it was the excessive concentration or risk, not leverage, that caused problems in financial markets (and it's an argument I'm sympathetic to):

Economic Witch Hunting, by Ricardo Caballero, Commentary, Economists Forum: Perhaps one of the economic phenomena most akin to witch-hunting is the diagnostic and policy response that develops during the recovery phase of a financial crisis. Understandably, pressured politicians and policymakers rush to find culprits... All too often they find a ready supply of these in preconceptions and superficial analyses of correlations. This time around the scapegoats are global imbalances and leverage.

Global imbalances are the victim of preconceptions: Many economists and commentators argued before the crisis that large global imbalances would lead to the demise of the U.S. economy... The crisis indeed came, but rather than destabilizing the US economy, capital flows helped to stabilise it, as flight-to-quality capital sought rather than ran away from US assets. ...

The fact that the actual mechanism behind the crisis had nothing to do with that which was used to explain the forecast of doom has long being forgotten, false idols have been erected,... global imbalances have been indicted for witchcraft, and ever more exotic rebalancing and currency proposals make it to the front pages of newspapers around the world.

Leverage is the victim of superficial analyses of correlations: In my view one of the main factors behind the severity of the financial crisis was the excessive concentration of aggregate risk in highly-leveraged financial institutions. Note that the emphasis is on the concentration of aggregate risk rather than on the much-hyped leverage. The problem in the current crisis was not leverage per se, but the fact that banks had held on to AAA tranches of structured asset-backed securities which were more exposed to aggregate surprise shocks than their rating would, when misinterpreted, suggest.

Thus, when systemic confusion emerged, these complex financial instruments quickly soured, compromised the balance sheet of their leveraged holders, and triggered asset fire sales which ravaged balance sheets across financial institutions. The result was a vicious feedback loop between assets exposed to aggregate conditions and leveraged balance sheets.

The distinction emphasized in the previous paragraph may seem subtle, but it turns out to have a first order implication for economic policy... The optimal policy response to this problem is not to increase capital requirements (or to deleverage), as the current fashion has it, but to remove the aggregate risk from systemically important leveraged financial institutions’ balance sheets. This should be done through prepaid and often mandatory macro-insurance type arrangements, which can accommodate valid too-big or too-complex to fail concerns, but without crippling the financial industry with the burden of brute-force capital requirements. ...

We shouldn't assume that the next potential financial crisis will be identical to this one in terms of how it comes about or how it expresses itself, so we need to ensure that the system can withstand different types of financial shocks. Given that these shocks can come from unexpected places, it's not clear to me that insurance discussed above will stop all of the ways in which financial market problems can lead to harmful deleveraging. Hence, we may want to put the type of insurance plan Ricardo Caballero would like to see instituted in place, and then buttress that protection with enhanced capital requirements to safeguard against unexpected causes of harmful deleveraging.

This post has been republished from Mark Thoma's blog, Economist's View.

Obama's Proposal For Requiring Bank "Funeral Plans"

An arguably much needed change outlined in the Obama administration's financial regulation overhaul proposal is the requirement of a "rapid resolution plan". This would provide the government with important information in the event that a systemically important financial institution faces collapse. For more, see the following post by economist Mark Thoma, author of Economist's View.

No disagreement with this. The failure to have dissolution plans for systemically important institutions on the shelf and ready to go turned out to be costly, so credible dissolution plans are certainly needed. However, the argument seems to assume that too big and too interconnected firms cannot be avoided, something I'm not ready to concede:

A sound funeral plan can prolong a bank’s life, by Anil Kashyap, Commentary, Financial Times: Buried within the 88-page Obama administration proposal to overhaul financial regulation is an overlooked option called a “rapid resolution plan”. It mandates that systemically important financial companies be required regularly to file a “funeral plan”: a set of instructions for how the institution could be quickly dismantled should the need to do so arise. ... It could be implemented now, without the need for legislative action. Regulators should do so immediately.

The first benefit is that regulators would gain a stronger negotiating position with a dying institution. Throughout this crisis the authorities have had to intervene without knowing exactly what hidden traps might emerge if a bank were to be closed down. The bankers know this and can exploit the fear of the unknown to press for bail-outs.

It is remarkable that such rules do not already exist. ... The crisis has shown us that the sudden unwinding of a large, complex financial institution is terrifying for the financial system. ...

A second immediate benefit would be to force bank managers to think much more carefully about the complex financial structures they have created. If bankers had to explain every single step needed (and the associated consequences) to shut down their subsidiaries in all the various jurisdictions in which they operate, they would have a big incentive to simplify their organisations. ...

Over the medium term, there would be additional benefits. The headline component of the plan would be the requirement for banks to estimate the number of days it would take to shut down. Banks that require longer to close would have to hold more capital. This would place management under serious pressure to improve their plans...

Senior members of the management team and the board would have to understand the funeral plan. Crucially, they would be forced to sign off on its accuracy. This might also lead to closer scrutiny of new products or lines of business if they jeopardised an orderly unwinding. ...

This proposal is far from a cure-all. One big problem is that resolution rules themselves, especially when multiple legal systems are involved, are quite complicated. But the plan has an extremely high benefit-to-cost ratio and could be put in place right away. ...

This post was republished from Mark Thoma's blog, Economist's View.

Preventing Regulators From Favoring Commercial Interests

Is Obama's proposal for regulation doing enough to prevent regulators from acting in the best interest of financial companies? That is the question that is posed by WSJ columnist Thomas Frank. Economist Mark Thoma responds to Frank's criticism.

Thomas Frank says the administration's regulatory overhaul plan is not putting enough emphasis on the problem of regulatory capture:

Obama and 'Regulatory Capture', by Thomas Frank, Commentary, WSJ: ...We have just come through the most wrenching financial disaster in decades, brought about in no small part by either the absence of federal regulation or the amazing indifference of the regulators.

This is the moment for a ringing reclamation of the regulatory project. President Barack Obama is clearly the sort of man who could do it. But ... a white paper his administration released on the subject last week ... uses bland, impersonal explanations for the current crisis. Regulatory agencies were ill-designed... Their jurisdictions overlapped. They had blind spots. They had been obsolete for years.

All of which is true enough. What the report leaves largely unaddressed, however, is the political problem. ... The people who filled regulatory jobs in the past administration were asleep at the switch because they were supposed to be. ...

The reason for that is simple: There are powerful institutions that don't like being regulated. Regulation sometimes cuts into their profits... So they have used the political process to sabotage, redirect, defund, undo or hijack the regulatory state since the regulatory state was first invented.

The first federal regulatory agency, the Interstate Commerce Commission, was set up to regulate railroad freight rates in the 1880s. Soon thereafter, Richard Olney, a prominent railroad lawyer, came to Washington to serve as Grover Cleveland's attorney general. Olney's former boss asked him if he would help kill off the hated ICC. Olney's reply ... should be regarded as an urtext of the regulatory state:

"The Commission . . . is, or can be made, of great use to the railroads. It satisfies the popular clamor for a government supervision of the railroads, at the same time that that supervision is almost entirely nominal. Further, the older such a commission gets to be, the more inclined it will be found to take the business and railroad view of things. . . . The part of wisdom is not to destroy the Commission, but to utilize it."

The George W. Bush administration elevated this strategy to a snickering, sarcastic art form. It gave us a Food and Drug Administration that sometimes looked as though it was taking orders from Big Pharma, an Environmental Protection Agency that could never rouse itself from the recliner, an energy policy that might well have been dictated by Enron, and a Consumer Product Safety Commission that moved like a rusty wind-up toy.

And it created a situation where banking regulators posed for pictures with banking lobbyists while putting a chainsaw to a pile of regulations. ...

Misgovernment of this kind is not a partisan phenomenon, of course. Democrats have been guilty of it as well as Republicans. ... Yet today we talk around this problem, with its nose-on-your-face obviousness, as though it didn't exist. It's not until page 29 of the Obama administration's densely worded white paper that you find a reference to "regulatory capture," and then it is buried in a list of items to be considered by a future Treasury working group. ...

[T]he administration must go further. ... After all, the Bush team was only able to install the dreadful regulators it did because the governance of federal agencies was rarely a topic of public debate in those days. Mr. Obama should make it an unavoidable subject, something that future politicians will be required to address. The issue cries out for it. And the nation, for once, is listening.

I see this a little bit different. I think the regulatory capture that helped to open the door for the current crisis had more to do with the adoption and promotion of free market ideology and the culture that ideology brought about within the regulatory bodies than to direct capture by regulated industries.

The financial industry certainly promoted the free market, self-healing, self-regulating approach since it coincided with their interests in shedding regulatory constraints, and they also aided politicians who promoted these ideas. Those politicians, in turn, made appointments to key positions within regulatory agencies that were designed to further this ideology and that, too, contributed to the changing culture within the regulatory bodies.

But the idea that, in almost all cases cases markets will self-correct and self-regulate, and that society is best served with a hands off approach to these markets, did not originate within industry. It came from a dominant strain of economic thought supported by theoretical models and empirical evidence. Without the support of these models, the empirical evidence, and the many economists who carried the message - and most of the profession did - it would have been much more difficult for industry to successfully promote the "deregulation is good for everybody always and everywhere" within the political and regulatory arenas.

I don't want to be mistaken here, I still believe that most markets function well with minimal regulation, and that a hands off approach is generally best. But I hope we have learned that financial markets are not among the markets for which this is true. I also hope that, as a profession, we will be more receptive to the idea that markets can fail, and can do so catastrophically, that we will build models that help us to better understand how to minimize the risk that markets will break down, and more importantly that we will interpret data with this in mind. All of the data in the world is useless if you cannot see, refuse to see, or cannot accept what it is trying to tell you.

This article was reposted from Mark Thoma's blog, Economist's View.

George Soros and Robert Reich: How To Reform The Financial System

Two very smart financial minds, legendary currency trader George Soros and former Secretary of Labor Robert Reich, share how they would reform the financial system. The people in charge of this momentous task would be wise to listen to what Soros and Reich propose. See the following post by Economist Mark A. Thoma from The Economist's View.

First, Robert Reich:

The Three Essentials of Financial Reform, by Robert Reich: As the White House unveils its long-awaited proposals to prevent another Wall Street meltdown in the future, keep a lookout for three essentials. Without them the Street will revert to its old ways as soon as the coast clears. ...

1. Stop bankers from making huge, risky bets with other peoples’ money. At the least, require they back their bets with a large percentage of their own capital, and bar them from raising money off their balance sheets through derivative trades. Also require they take their pay in stock options or warrants that can’t be cashed in for at least three years, so they’ll take a longer-term view. Best of all would be a requirement that investment banks return to being partnerships and the capital on their books be their own, not yours or your pension fund’s. When investment banks were partnerships, every partner took an active interest in what every other partner and trader was doing. The real mischief started once they started selling shares to the public.

2. Prevent any bank from becoming too big to fail. Separate commercial from investment banking... Combining the basic utility with the casino only made bankers far richer and subjected you and me to risks we didn’t bargain for. If separating commercial from investment banking isn’t enough to bring all banks down to reasonable size, use antitrust laws to break them up.

3. Root out three major conflicts of interest. (1) Credit-rating agencies should no longer be paid by the companies whose issues are being rated; they should be paid by those who use their ratings. (2) Institutional investors like pension funds and mutual funds should not be getting investment advice from the same banks that profit off their investments... (3) the regional Feds that are responsible for much bank oversight should no longer be headed by presidents appointed by the region’s bankers; non-bankers should have the major say, and the regional presidents should have to be confirmed by the Senate.

..[T]he big bankers will fight every one of these with all guns blazing, and their lobbyists in full force. ... Bottom line: Genuine financial reform will be almost as difficult to achieve as real universal health care. Immense private interests are amassed against the public interest in both cases because staggering amounts of money are at stake. ...

Second, George Soros:

The three steps to financial reform, by George Soros, Commentary, Financial Times: ...I am not an advocate of too much regulation. ... While markets are imperfect, regulators are even more so. ... Three principles should guide reform. First, since markets are bubble-prone, regulators must accept responsibility for preventing bubbles from growing too big. Alan Greenspan ... expressly refused that responsibility. ...

Second,... we must also control the availability of credit..., we must ... use credit controls such as margin requirements and minimum capital requirements. ... Margin and minimum capital requirements should be adjusted to suit market conditions ... to forestall ... bubbles.

Third, we must reconceptualise the meaning of market risk. The efficient market hypothesis postulates that markets tend towards equilibrium and deviations occur in a random fashion...

But the efficient market hypothesis is unrealistic. Markets are subject to imbalances... If too many participants are on the same side, positions cannot be liquidated without causing a discontinuity or, worse, a collapse. In that case the authorities may have to come to the rescue. That means that there is systemic risk ... in addition to the risks most market participants perceived prior to the crisis.

The securitisation of mortgages added a new dimension of systemic risk. Financial engineers claimed they were reducing risks through geographic diversification: in fact they were increasing them by creating an agency problem. The agents were more interested in maximising fee income than in protecting the interests of bondholders. ...

To avert a repetition, the agents must have “skin in the game” but the five per cent proposed by the administration is more symbolic than substantive. ...

It is probably impractical to separate investment banking from commercial banking as the US did with the Glass Steagull Act of 1933. But there has to be an internal firewall...

Finally, I have strong views on the regulation of derivatives. The prevailing opinion is that they ought to be traded on regulated exchanges. That is not enough. The issuance and trading of derivatives ought to be as strictly regulated as stocks. ... Custom made derivatives only serve to improve the profit margin of the financial engineers designing them. In fact, some derivatives ought not to be traded at all. ... Consider the recent bankruptcy of AbitibiBowater and that of General Motors. In both cases, some bondholders owned CDS and stood to gain more by bankruptcy than by reorganisation. It is like buying life insurance on someone else’s life and owning a licence to kill him. CDS are instruments of destruction that ought to be outlawed.

Third, in response to this, and more generally to the recent argument that calls to extend regulation to the shadow banking sector are unfounded because this sector had nothing to do with the crisis (which is incorrect), for the second time recently here's well-know socialist sympathizer Robert Lucas, the Nobel prize winning economist at the University of Chicago. It seems he also favors extending regulation to the unregulated banking sector:

The regulatory structure that permitted these events to occur will have to be redesigned... The regulatory problem that needs to be solved is roughly this: The public needs a conveniently provided medium of exchange that is free of default risk or "bank runs." The best way to achieve this would be to have a competitive banking system with government-insured deposits.

But this can only work if the assets held by these banks are tightly regulated. If such an equilibrium could be reached, it would still be possible for an institution outside this regulated system to offer deposits that are only slightly more risky but that also pay a higher return than deposits at the regulated banks. Some consumers and firms will find this attractive and switch their deposits. But if everyone does, the regulations will no longer protect anyone. The regulatory structure designed in the 1930s seemed to solve this problem for 60 years, but something else will be needed for the next 60.

And you don't need everyone to switch, just enough to create systemic risk.

This article has been reposted from the Economist's View. The full post can also be viewed on the Economist's View.