I understand that with very complicated things people often use shortcuts and heuristics to try and narrow down ideas to fit into already existing mental boxes. Especially with financial reform, where it can be mind-numbingly tedious at points, it’s easy to just take the standard narrative and accept it.
Like “the vanilla option” approach to consumer financial reform. If you follow financial reform a little bit, you probably saw that this, the move to make financial instruments more standardized, more transparent, and more easily comparable between institutions, was thrown overboard really early. You probably saw that I and other people on the left were disappointed, and conservatives were happy. And you may have thought “Well if it’s too lefty for Barney Frank it’s probably best that it went….” I don’t blame you – I’d probably do the same thing in your case.
But! Let’s look at the idea from a different point of view. Let’s jump forward to a speech given recently by Kevin Warsh, a member of the Board of Governors of the Federal Reserve System to the New York Association for Business Economics. The speech is titled Regulation and Its Discontents.
Simon Johnson looks at the speech in detail, and thinks it may signal a changing point. I like it too, and I’d recommend checking out the speech and Simon’s take. But I want to point out one part of it that I wasn’t expecting (my underline):
First, in order to resurrect market discipline from the ash-heap of the recent crisis, stakeholders–that is, shareholders, creditors, and regulators alike–need better, more timely information about financial firms. Information-sharing is growing exponentially in all aspects of human endeavor. Financial firm disclosures should be no exception.
Asset quality and funding sources for financial firms must be more understandable and readily comparable among peers. Stakeholders can then make better informed judgments of potential risks and rewards. Markets can help effectively discipline the behavior of firms by re-pricing funding costs as perceived risks change. And regulators can use market prices and changes in funding mix, among other information, to evaluate whether firms are being evaluated independent of government backing.
Check that out again. He wants vanilla options for creditors and shareholders! Understandable and comparable between institutions. It’s exactly the same point Steve Waldman has made elegantly (here and here) about vanilla loans in the consumer financial sector.
I was pleasantly surprised to see this in the speech. Instead of running to navel-gazing models of the economy, where everyone is perfectly informed if you just aggregate enough of them, he rightfully catches that there’s a huge incentive in distorting what kinds of information is available, and it’s very profitable to make it harder to compare your performance to someone else’s.
Warsh is saying that people who live and breathe these markets need information about quality that is readily comparable to peer groups. That’s the way that stakeholders can bring market discipline to financial firms. That’s the same exact argument the vanilla crew is bringing to mortgages, credit cards, checking accounts, etc.
But What About Me?
So see? Not a fringe concept in the slightest. And the longer battle here isn’t over because Frank and Geithner kicked it overboard.
Now I know what you are thinking: “Mike, I understand what you are getting at. But that’s the financial markets. It’s only people with huge amounts of money at stake, elite educations, armies of high-energy physics PhD who should be developing new energy sources but are running prop trading desks for some reason and vast amounts of personal as well as institutional knowledge. I see why those creditors and shareholders could use some vanilla options based reform. But as a random dude or dudette off the street, I’m waaayyy more sophisticated than all that. Why do I need vanilla options?”
That’s an excellent point. But note that Warsh’s point is that it isn’t just about protecting shareholders and creditors – though it does do that. It’s about actually allowing market information to do its job. Without a kind of broad-based vanilla approach, there’s huge incentives and profits in innovating means to hide costs, amplify unexpected fees, mechanisms which can drive out better functioning firms. And to the extent that one side of finance is much more easily able to bargain with another side of finance, it’s much harder for consumers to do this. Especially when you get into a high-fee, low-cost, huge-transfer equilibrium that we have found ourselves in.