I’ve written so much about the Dodd-Frank Bill that I’m kind of exhausted with it. But Mark Thoma and Noah Millman, using the same list, write out their thoughts on the financial reform bill. I’m a fan of Noah writing about finance and both are worth reading. I’m going to add a few high-level thoughts to what they wrote using their framework.
Consumer Protection Agency. A lot of the headache we are suffering through now could have been avoided if Alan Greenspan enforced consumer protection laws in the subprime market, notably the 1994 The Home Ownership and Equity Protection Act. Ned Gramlich urged Greenspan to have the Fed start regulating subprime, which he could do when HSBC and others started buying out subprime lenders. So did the GAO and a HUD-Treasury task force. Greenspan wouldn’t. And here we are. Having consumer protection as a third or fourth priority across many agencies doesn’t cut it: We need an agency with this as its first priority. The benefit in fraud pays out more than the penalties with the way the current system works. As much as some like this system because it punishes people or cross-subsidizes those who have extra money, overall it’s a system that could use some simple guidelines in contract writing and law enforcement.
Also: At heart, I’m a data nerd, so the ability of the CFPB to collect, analyze, research and make data public is one of the most interesting pieces of it. We might get better data on consumer debt than the of-interest-to-only-macroeconomists aggregate data that is currently public. And that data and research can give us a better picture of who the financial sector work well for and who it doesn’t work for at all.
Derivatives Traded on Exchanges. Noah: “What was important was the lack of a central clearinghouse because that meant that there was no generally agreed upon mechanism for establishing valuations and posting collateral. AIG was insuring huge amounts of risk and posting nothing; then they got downgraded, had to start posting collateral, therefore had to come up with some idea of what their stuff was actually worth, and rapidly entered a death spiral. If derivatives all trade through a central clearing corporation, then everybody has to post collateral and leverage is limited by the clearing corporation. That’s the way the listed options market works and the way the listed futures market works, and it’s how the credit derivatives market should work as well. And, as a side effect, you probably get better price discovery. So this is a good reform.”
I agree. I worry about the “end-user” exemption getting defined too broadly, and industrials being encouraged to run mini-hedge funds out of their offices and other juking through this mechanism. This is something to be monitored for years to come – how many derivatives are being cleared, on what terms are swap execution facilities being defined, and how much price transparency are market agents getting?
Resolution Authority. Noah: “This is a vital reform but people should understand that it has a very limited effect. Basically, this gives regulators the authority to do with a future AIG what they could do with a normal bank. That eliminates a big element of uncertainty going into negotiations between regulators and the company in question during a crisis, and therefore should mitigate the market panic during a crisis. It doesn’t address any questions of fairness associated with bailouts, and it doesn’t really do anything to prevent a crisis from happening, but it should prevent another Lehman Brothers-type total market meltdown when the next crisis occurs. If you look at the difference between how Lehman and Washington Mutual were handled respectively, you can see the vital importance of this reform.”
I mostly agree. I am still up in the if we would have actually used this resolution authority on Lehman and/or Bear in 2008. I like to think we would have, but there’s some uncertainty there.
Too Big To Fail. I’ll take this as the SAFE Banking Amendment.
I’ll discuss this more in Leverage Ratios below, but I’m skeptical on Basel III getting a solid handle of liquidity-reserving requirements, and the SAFE Banking Amendment putting a hard cap on non-deposit liabilities would have saved us a lot of headache in praying that the international banking community doesn’t destroy a moderate “Bear Stern Rule” on liquidity through the process. Beyond that, the political pressures of the biggest banks, the lack of demonstrable value, the fact that the biggest players didn’t do any better worse in the stress test in terms of expected losses for all their magic “diversification”:
And the number of other reasons, including whether or not resolution authority is credible on an institution with 7% of GDP in non-deposit liabilities, made me think this would have been a smart move.
Volcker Rule Too Weak. The 3% loophole is a sad thing to see. The banks were gunning for 10%, so I do have to give credit for what they were able to keep Brown et al to in terms of the size of the loophole. But for a clear boundary to keep our commercial banks from becoming de facto hedge funds and having the huge asymmetry in payouts that come with picking up nickels in front of a steamroller it is a shame.
Fed Audits. In general I am in favor of public scrutiny of emergency powers in a crisis, and the trillions of dollars that the Federal Reserve decided to lend out in the middle of a crisis deserves a public record. There needs to be a symmetry to emergency powers: yes you can take them if necessary to stabilize the system, but you have to allow the public to actually see what was done.
Limits on Leverage. This is one of the problems that new limits on leverage will have to deal with, from The Economist’s Free Exchange:
This bill doesn’t fix “the shadow banking system” entirely. The crisis has underscored the fragility of shadow banks’ funding model, which relies on confidence-sensitive wholesale markets to support credit-intensive assets. We get regulators directed for banks to hold extra capital for liquidity, with the rules being kicked to Basel III. Looking at two liquidity parts of the proposal: “The liquidity proposals come in two parts: one, known as the Bear Stearns rule, requires banks to have enough liquid assets on hand to survive a 30-day crisis, while the other, nicknamed the Northern Rock rule, requires banks to have stable long-term funding, favouring deposits and heavily disfavouring wholesale sources.” These two proposals are being lobbied against hard, especially the second part. I’d like these rules better if we had a hard rule on non-deposits as a percent of GDP, aka the SAFE Banking Act.
Monitoring Systemic Risk. I think it’s less of an issuing of monitoring bubbles versus knowing how to react to them. There’s clear evidence that Greenspan knew of the housing bubble early on, but decided to not take public action, and deal with the cleanup afterwards. Is that how it is going to go again?
Executive Pay. To the topic of pay more generally, if you have traders and others making “f*** you money” (or “walkaway money”) every year, it’s going to be tough for them to think in terms of the long-term health of the firm.
Credit Ratings Agencies. The people I know who teach CFA classes are frightened at how institutionalized the Ratings Agencies are into the practice of capital reserving. Like the materials can’t imagine a world outside of a ratings mindset. That’s worrisome, though I am no longer at the front lines on this. There’s always been a conflict of interest, but in the case of the AAA securitization it’s impossible to imagine any demand being there if they were AA rated. This bill opens up a lot of the ratings agency’s model; I’m curious as to how banks handle credit risk 5 years from now.