Tip-toe Regulatory Reform
Henry C.K. Liu

This article appeared in AToL on June 18, 2009 and in NewDeal 2.0, a project of the Franklin and Eleanor Rossevelt Institute.
Treasury Secretary Tim Geithner and National Economic Council Director Larry Summers jointly penned an op-ed piece in the Washington Post on Monday, June 15, 2009 to lay out the policy goal of the Obama administration's regulatory reform plan to be announced two days later.
The essay describes the current financial crisis as “the product of basic failures in financial supervision and regulation”, by pointing out that “our framework for financial regulation is riddled with gaps, weaknesses and jurisdictional overlaps, and suffers from an outdated conception of financial risk. In recent years, the pace of innovation in the financial sector has outstripped the pace of regulatory modernization, leaving entire markets and market participants largely unregulated.”

Yet the administration’s regulatory reform plan is generally viewed as having backed away, due to the political difficulties involved, from a more extensive structural overhaul that would have consolidated all banking regulation into one unified agency.
The op-ed essay identifies “five key problems in our existing regulatory regime -- problems that, we believe, played a direct role in producing or magnifying the current crisis.”

The essay states: “First, existing regulation focuses on the safety and soundness of individual institutions but not the stability of the system as a whole. As a result, institutions were not required to maintain sufficient capital or liquidity to keep them safe in times of system-wide stress. In a world in which the troubles of a few large firms can put the entire system at risk, that approach is insufficient. The administration’s proposal will address that problem by raising capital and liquidity requirements for all institutions, with more stringent requirements for the largest and most interconnected firms. In addition, all large, interconnected firms whose failure could threaten the stability of the system will be subject to consolidated supervision by the Federal Reserve, and we will establish a council of regulators with broader coordinating responsibility across the financial system.”

Yet, capital adequacy for large financial firms, while important, will not by itself eliminate systemic risk since systemic meltdown can be caused by massive counterparty defaults on the part of large number of small firms and investors holding structured finance instruments that are off the balance sheets of the big firms to cause insolvency of the big firms. The problem is that even small firms are now "too big to fail" because of opaque interconnectedness which can cause the system to fail not at its big nodes but at its weakest points throughout the system. The administration’s two top economists do not see fit to blame run-away "innovation", only the failure of regulation to keep pace with it. That is like blaming bank guards for bank robbers.

The essay states: "Second, the structure of the financial system has shifted, with dramatic growth in financial activity outside the traditional banking system, such as in the market for asset-backed securities. In theory, securitization should serve to reduce credit risk by spreading it more widely. But by breaking the direct link between borrowers and lenders, securitization led to an erosion of lending standards, resulting in a market failure that fed the housing boom and deepened the housing bust. The administration’s plan will impose robust reporting requirements on the issuers of asset-backed securities; reduce investors’ and regulators’ reliance on credit-rating agencies; and, perhaps most significant, require the originator, sponsor or broker of a securitization to retain a financial interest in its performance. The plan also calls for harmonizing the regulation of futures and securities, and for more robust safeguards of payment and settlement systems and strong oversight of ‘over the counter’ derivatives. All derivatives contracts will be subject to regulation, all derivatives dealers subject to supervision, and regulators will be empowered to enforce rules against manipulation and abuse."

The non-banking financial system is essentially an anti-banking system in that it allows securitization to convert debt into security, i.e. credit into capital. It is an insurgent war against capitalism itself. Pension funds are allowed to invest in debt instruments as if it were security instruments. Such instruments are in reality stripped of security, with returns commensurate with risk levels. The word security is derived from the Ancient Greek “Se-Cura” and literally translates to “without fear”. Structured finance actually promotes fearlessness that no regulation can negate.

The essay states: “Third, our current regulatory regime does not offer adequate protections to consumers and investors. Weak consumer protections against subprime mortgage lending bear significant responsibility for the financial crisis. The crisis, in turn, revealed the inadequacy of consumer protections across a wide range of financial products -- from credit cards to annuities. Building on the recent measures taken to fight predatory lending and unfair practices in the credit card industry, the administration will offer a stronger framework for consumer and investor protection across the board."

Improved consumer protection is certainly needed, but the best way to protect the consumer is to adopt a full employment economy with rising wages so that workers do not have to assume unsustainable debt in order to buy the products they make.

The essay states: “Fourth, the federal government does not have the tools it needs to contain and manage financial crises. Relying on the Federal Reserve's lending authority to avert the disorderly failure of nonbank financial firms, while essential in this crisis, is not an appropriate or effective solution in the long term. To address this problem, we will establish a resolution mechanism that allows for the orderly resolution of any financial holding company whose failure might threaten the stability of the financial system. This authority will be available only in extraordinary circumstances, but it will help ensure that the government is no longer forced to choose between bailouts and financial collapse.”

There is no “appropriate” government mechanism to contain and manage financial crises. The solution is to prevent recurring financial crises.  A new resolution mechanism to shift private debt into public debt does little to prevent recurring financial crises. In fact, it may well make such crises routine.

The essay states: "Fifth, and finally, we live in a globalized world, and the actions we take here at home -- no matter how smart and sound -- will have little effect if we fail to raise international standards along with our own. We will lead the effort to improve regulation and supervision around the world."

promotion of neoliberal globalization of trade and finance has been the main cause of recurring global financial crises. The lack of international labor standards and wage scales has permitted US corporations to exploit cross-border wage arbitrage that has caused global wage stagnation to generate wage/price imbalance, notwithstanding the essay’s misapplied claim of a saving/consumption imbalance. US opposition to international financial regulatory standard has allowed US financial firms to exploit cross-border arbitrage of risk in the name of innovation.

Neither the op-ed essay nor the administration’s plan addresses the need for a Federal regulatory regime for the insurance sector which is now governed by state insurance commissions in a tradition of state rights. This issue is particularly central since under-regulated financial risk insurance practices have been a key contributor to run-away systemic risk.

The administration aims to curb excessive risk-taking through reform of structured finance and compensation practices that encourages risk taking, including “say on pay” for shareholders and regulation against abuses of risk induced by short term compensation while leaving the penalty of future loss to shareholders.

Under the Obama plan, the Fed will retain day-to-day supervision of the largest bank-holding companies, which the Bush administration had proposed taking away. The Fed may become the sole regulator for both banks and non-banks financial companies that reach a comparable size and complexity. The Fed is also likely to be given the final authority on bank capital requirements, including a surcharge for the systemically important financial institutions.
However, not all systemic risk powers will be concentrated in the Fed. The Obama plan will propose giving the Federal Deposit Insurance Corporation (FDIC) special resolution powers to wind down important large financial institutions. These powers will extend the capacity of FDIC to manage the orderly failure of a complex financial company, which policymakers hope will mitigate the moral hazard created by recent bail-outs.
Nonetheless, the plan places great reliance on the Fed which is likely to be controversial in Congress, with critics charging that the Fed had failed to exert its existing regulatory powers over banks in mortgage lending.

It was not as if the Fed failed to spot the serial bubbles. It crested them by policy. Greenspan, notwithstanding his denial of responsibility in helping through the 1990s to unleash the equity bubble, had this to say in 2004 in hindsight after the bubble burst in 2000: “Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences, we chose, as we noted in our mid-1999 congressional testimony, to focus on policies to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.”

By the next expansion, Greenspan meant the next bubble which manifested itself in housing. The mitigating policy was a massive injection of liquidity into the banking system. There is a structural reason why the housing bubble replaced the high-tech bubble. (See my September 14, 2005 article: Greenspan, the Wizard of Bubbleland)

Alan Greenspan, who from 1987 to 2006 was chairman of the Board of Governors of US Federal Reserve - the head of the global central banking snake by virtue of dollar hegemony - embraced the counterfactual conclusion of Milton Friedman that monetarist measures by the central bank can perpetuate the boom phase of the business cycle indefinitely, banishing the bust phase from finance capitalism altogether.

Going beyond Friedman, Greenspan asserted that a good central bank could perform a monetary miracle simply by adding liquidity to maintain a booming financial market by easing at the slightest hint of market correction.

This ignored the fundamental law of finance that if liquidity is exploited to manipulated excess debt as phantom equity on a global scale, liquidity can act as a flammable agent to turn a simple localized credit crunch into a systemic fire storm.

Ben Bernanke, Greenspan's successor at the Fed since February 1, 2006, also believes that a "good" central banker can make all the difference in banishing depressions forever, arguing on record in 2000 that, as Friedman claimed, the 1929 stock market crash could have been avoided if the Fed had not dropped the monetary ball. That belief had been a doctrinal prerequisite for any candidate up for consideration for the post of top central banker by President George W Bush. Yet all the Greenspan era proved was that mainstream monetary economists have been reading the same books and buying the same counterfactual conclusion. Friedman's "Only money matters" turned out to be a very dangerous slogan.

Both Greenspan and Bernanke had been seduced by the convenience of easy money and fell into an addiction to it by forgetting that, even according to Friedman, the role of central banking is to maintain the value of money to ensure steady, sustainable economic growth, and to moderate cycles of boom and bust by avoiding destructively big swings in money supply. Friedman called for a steady increase of the money supply at an annual rate of 3% to achieve a non-accelerating inflation rate of unemployment (NAIRU) as a solution to stagflation, when inflation itself causes high unemployment. (Please see my January 6, 2009 AToL article: Montarism Enters Bankruptcy)

The Kansas City Federal Reserve Bank annual symposium at Jackson Hole, Wyoming, is a ritual in which central bankers from major economies all over the world, backed by their supporting cast of court jesters masquerading as monetary economists, privately rationalize their unmerited yet enormous power over the fate of the global economy by publicly confessing that while their collective knowledge is grossly inadequate for the daunting challenge of the task entrusted to them, their faith-based dogma nevertheless should remain above question. In 2005, the annual august gathering of cnetral bankers in August took on special fanfare as it marked the final appearance of Alan Greenspan as chairman of the US Federal Reserve Board of Governors. Among the several interrelated options of controlling the money supply, the Federal Reserve, acting as a fourth branch of the US government based on dubious constitutional legitimacy and head of the global central-banking snake based on dollar hegemony,  has selected interest-rate policy as the instrument for managing the economy all through the 18-year stewardship of Alan Greenspan, on whom many accolades were showered by invited participants in the Jackson Hole seminar in anticipation of his retirement early the next year.

Greenspan's formula of reducing market regulation by substituting it with post-crisis intervention is merely buying borrowed extensions of the boom with amplified severity of the inevitable bust down the road. The Fed is increasingly reduced by this formula to an irrelevant role of explaining an anarchic economy rather than directing it towards a rational paradigm. It has adopted the role of a cleanup crew of otherwise avoidable financial debris rather than that of a preventive guardian of public financial health. Greenspan's monetary approach has been "when in doubt, ease". This means injecting more money into the banking system whenever the US economy shows signs of faltering, even if caused by structural imbalances rather than monetary tightness. For almost two decades, Greenspan has justifiably been in near-constant doubt about structural balances in the economy, yet his response to mounting imbalances has invariably been the administration of off-the-shelf monetary laxative, leading to a serious case of lingering monetary diarrhea that manifests itself in runaway asset price inflation mistaken for growth.(Please see  my September 14, 2005 AToL article:
Greenspan, the Wizard of Bubbleland)

Fed chairman Ben Bernanke believes that macroprudential powers (systemic risk powers) may allow a central bank to prevent credit and asset price bubbles not easily addressed with interest rates. But other Fed officials are apprehensive that the central bank is setting itself up for predictable failure, and that the exercise of macroprudential powers will entangle the Fed in political fights that will undermine independent monetary policy-making.

Larry Summers likes to say the Obama administration inherited the financial crisis from the Bush administration, but the Obama plan for regulatory reform essentially inherits the Henry Paulson plan. Paulson advocated consolidation of a regulatory regime “largely knit together over the last 75 years, put into place for particular reasons at different times and in response to circumstances that may no longer exist.”  The Geithner plan eliminates the Office of Thrift Supervision (OTS) which oversaw an array of collapsed large institutions such as IndyMac, Washington Mutual and AIG. OTS is to be merged with the Office of the Comptroller of the Currency (OCC).  The shotgun marriage was first proposed by Paulson.

Paulson also wanted to merge the Commodity Futures Trading Commission (CFTC) into the Securities and Exchange Commission (SEC) to ensure that derivatives, the weapons of mass financial destruction, would be properly put under financial arms control. The proposal is not in the Geithner plan not because the Treasury did not like the idea but because the CFTC, with long historical tie to Chicago, has a powerful lobby. But the SEC will have to devolve some power to a new commission responsible for supervising consumer financial products.

Plans on securitization will force lenders to retain at least 5 per cent of the credit risk of loans that are securitized. Asset-backed securities and the entire over-the-counter derivatives market will face new reporting rules. Large “systemically risky” institutions will have to hold more capital, and hedge funds will have to provide more data on their trading positions. George Soros, the speculator who broke the Bank of England over its defense of the pound sterling, said in the Financial Times that a requirement for lenders selling securitized loans as securities to retain 5 per cent exposure “is more symbolic than substantive”. Yet the wider regulatory reform plan has already attracted criticism from bankers who say it will add to the cost of capital.
Republicans are preparing to fight several of the Obama proposals, with lawmakers particularly skeptical about giving more powers to the Federal Reserve, even though much of the Obama plan has been inherited from the previous Republican administration.

June 17, 2009