A little extra reaction from yesterday’s announcement.
First, back in October Deputy Director of the National Economic Council Diana Farrell famously told NPR:
We have created them [our biggest banks], and we’re sort of past that point, and I think that in some sense, the genie’s out of the bottle and what we need to do is to manage them and to oversee them, as opposed to hark back to a time that we’re unlikely to ever come back to or want to come back to.
It appears that after Tuesday’s election in Massachusetts the White House is going to go and find a bigger bottle. That quote always unsettled me, particularly the phrasing of “manage them and oversee them” instead of “regulate them”, and the dismissal of those who are worried about the concentration of, and power exerted by, structures of the financial industry. Is the narrative changing?
I wonder if there will be a crackup in Obama’s team over this. I’ve blogged before about the conspicuousness of Volcker missing from decisions, and I assume that this is a move away from the “genie’s out of the bottle” approach to the financial sector. Reuter’s seems to near a story of Geithner going rogue, see this PBS interview too.
The most obvious critique of the bill is that it is necessary but not sufficient for financial reform. Yes. 100% true. But good pieces of financial reform strengthen each other: they make each other more capable of being done, and regulators being capable makes reform more credible, reducing moral hazard.
Other pieces of reform need to move with this in order to make it work. If you take the hedge fund inside a commercial bank and break it out, you still have this floating piece of risk-making out there, just like Bear Stearns, AIG, etc. So it is incredibly important that regulators will have the proper tools to wind down these institutions, including resolution authority to do FDIC-like takeovers with clearly defined rules and procedures, and clearinghouses or exchanges for derivatives, so derivatives can be properly capitalized and the information about holdings will circulate and cause less panic. It’s all works together, and what this bill will do is keep commercial banks in large part fenced off from hedge funds that may implode, which makes resolution authority more credible and effective.
We have heard less from the administration about these two pieces, and how crucial they are. They are wonky, detailed, and headache inducing to think about (though we try our best here at explanation), but they are important.
Tim Carney, the author of Obamanomics, who is always on the lookout for when a regulation really becomes a subsidy for big business, doesn’t see a there there for this regulation. The problem is that the current system of keeping prop trading within banks, especially large ones, is already is a gigantic subsidy.
One problem with the way hedge funds work in theory – that they are highly informed arbitrageurs who use high leverage to keep markets efficient – is that there are limits of arbitrage. That’s a fancy math way of saying “the market can stay irrational longer than you can stay solvent.” If you are making a highly leveraged bets that two bonds will converge in price, but if they diverge further before they converge, you could be wiped out. That’s what happened to Long Term Capital Management, and it’s a problem for hedge funds.
One way to get around it would be if you had a safety net that provided you liquidity via the taxpayer, say from the Federal Reserve discount window. This window is a system designed to keep commercial banks solvent through bank runs; it can obviously be co-opted to keep hedge funds solvent if the market moves away from you become it comes back. That’s a gigantic advantage for the largest and most connected firms. Removing it creates a more even playing field.
(Another way it is beneficial is that, to simplify, many hedge fund strategies are so saturated that one firm exiting the strategy can set off a run in the price that forces everyone to exit. See “What Happened to the Quants in August 2007?” by Andrew Lo for an example. Someone with deep pockets, especially taxpayer provided deep pockets, can potentially make some killings unfairly by manipulating this, ie – by introducing systematic risk into the system, forcing margin calls on their non-subsidized competition and cleaning up in the process. I’m still uncertain about this in practice, but it’s something to worry about.)
And we aren’t even talking that much about the conflict-of-interest that is in play here, where large connected firms can trade ahead of their clients, which sucks for their clients, but also ahead of their smaller competition. This is hard to find, and forcing it off the table is the easiest solution.
Economics of Contempt has some thoughts about the 21st Century Glass-Steagall, as well as a critique of exchange-based derivatives reform I wrote about previously (which I’ll respond to soon), and you should check them out. This is important:
Some people will claim that it’s impossible to distinguish between market-making trades and propietary trades, but that argument is completely baseless. The banks themselves already distinguish between their market-making trades and their proprietary trades, as there’s a whole different set of rules for proprietary versus market-making trades. So don’t be fooled by that argument.
Remember that, because everyone is going to try to bring that up. As far as I understand it, market-making is not effected by this. And getting regulators involved at this level will have them with a closer eye on the books of the banks they are regulating. EoC also offers:
In any event, I don’t even know why I took the time to write about this, because there’s zero chance the proposals Obama announced today will ever be law…I like how some people think Obama’s proposals represent a fundamental turning point on financial reform, because….well, clearly this is their first rodeo.
This is my first rodeo, but as I’ve stated before, I view financial reform as a long project, perhaps even generational, and not a 2010 project. And here’s the thing for everyone at this rodeo – I highly doubt a financial reform bill is going to pass the broken Senate this year with the filibuster in place. Frank’s bill, even after it was watered down to meet every request of the blue dogs, barely made it out of the House. Not a single Republican voted for it.
When it came to regulating derivatives, an issue that should worry you if you followed the FCIC hearings as every person thought it was necessary, only one Republican voted to get it out of committee. One! For what is one of the most important pieces that needs to move. Will the Senate be any easier?! No. Are there any Republicans in front of this bill championing it on? None that I can see, and after the Brown win I expect them to hold the ball more tightly, and double down on rhetoric of the evil CRA and the moral hazard of having FDIC-insured checking accounts.
The smart move is not to turn financial reform into a compromised, counterproductive mess just so it too can be killed last minute, but make a principled stand for what real reform would look like, a marker for those who are with reform, and go from there.