Obama’s finance reform speech fizzles; big banks set to reinflate bubble

Marshall Auerback here. I have been posting at an interesting new site called New Deal 2.0. You may have seen Edward linking out to articles on the site.

Edward saw an article I wrote there recently and asked me to post it here as well to highlight a recurrent theme at Credit Writedowns – namely that economic recovery necessarily means a return to business as usual.

Please do comment.

The President has marked the anniversary of the demise of Lehman Brothers with a new speech designed to breathe new life into his financial reform proposals. But the Obama administration already forfeited its best chance to reform the banking system when the crisis was at its height.

For all of the lofty talk about establishing “the most ambitious overhaul of the financial system since the Great Depression”, Obama’s reforms amount to nothing more than a reshuffling of the deckchairs on the Titanic.

Why? Because Too big to fail (TBTF) banks have grown even more bloated in the past 2 years. And because leverage has increased across the board. Bank of America, the biggest of the “TBTF” institutions, now holds 12% of all US deposits. The top four (Bank of America, JPMorgan Chase, Citigroup and Wells Fargo) now have 46% of the assets of all FDIC-insured banks, up from 37.7% a year ago. Goldman Sachs, the biggest securities firm before it was handed a bank charter, has plunged into even riskier business and upped its trading and investment profits by two-thirds over the past year.

Systemic banks benefit from implicit and explicit government backstops. But a resolution regime for all systemically large and complex institutions like Fannie and Freddie — arguably one of the most important measures– is stalling in Congress amid waning political support. And — surprise! – lobbyist are gearing up to fight the Consumer Financial Protection Agency, whose fate is unclear as the bill works its way through Congress.

We haven’t yet even determined who will be the systemic risk regulator. Could be the Fed. Or it could be the Systemic Risk Council (a new body proposed to keep an eye of financial markets ). Given the Federal Reserve’s dismal record in anticipating this crisis and promoting the wrong-headed economic models that blew up the bubble, it is extraordinary that we are even discussing the notion of providing the central bank with yet more power. But is a Systemic Risk Council really the answer? Why reinvent the wheel, when the obvious alternative is the Federal Deposit Insurance Corporation (FDIC)?

Professor James Galbraith warns that the key ingredients in systemic risk regulation are accountability and supervision.

It would be all too easy for the Federal Reserve Board to open an internal Office of Systemic Risk Assessment, to staff it with mathematical risk modelers, and to let the matter rest there. Then, when the next crisis hits, the Fed would say that it was something ‘no one could have foreseen’ – just because their internal model-builders failed to foresee it. This is probably not the outcome Congress seeks…

….Essentially, the job is to recognize emerging patterns of dangerous behavior. This function is best taken on by an agency with experience, expertise, and focus on these functions, an agency with no record of regulatory capture or institutional identification with the interests of the regulated sector.

In Gailbraith’s view, the FDIC fits the bill. And he is right. The FDIC is the logical home for systemic regulation. Yet as far as we can see, Obama is not considering it in his proposals. Perhaps part of this reluctance reflects animus toward Sheila Bair, who is definitely not part of the “old boys’ network”. It also likely reflects the comfort level of Wall Street, given its incestuous relationship with the Fed, and the concomitant embrace by both groups of a like-minded market fundamentalist ideology.

Clearly a regulator should not be chummy with the entities it is charged with regulating. The FDIC is charged with taking over any bank it deems insolvent, and then either selling that bank, selling the bank’s assets, reorganizing the bank, or any other similar action that serves the public. This largely explains why the FDIC is not particularly beloved by Wall Street or Wall Street’s main benefactors in Washington DC.

Indeed, the TARP program was at least partially established to allow the US Treasury to subvert the role of the FDIC. By injecting equity in specific banks, the Treasury managed to keep them from being declared insolvent by the FDIC, and ostensibly allow them to continue to have sufficient capital to continue to lend. The end result? TARP entrenched the dominance of the largest financial institutions, preserving many which were de facto insolvent, at the expense of the better run local, community banks (which are in effect being penalized for the sins of Citi and Bank of America). The big bank problem is one of insolvency; further big banks cannot be and should not be saved. They do not hold the key to recovery; if anything, they are a barrier to sustainable recovery. Given a chance, they will try (in fact, ARE trying) to re-inflate the bubble conditions that led to this crisis. There is nothing in the proposed new regulatory framework which will prevent this.

Additionally, the history of banking crises suggest that the regulatory focus on the liability side of the banks’ balance sheets is faulty. There is much discussion of counter-cyclical capital requirements, but the reality is that capital standards and leverage ratios for financial institutions almost never work. They are always set so low that they allow leverage that would have been viewed as extreme as recently as 30 years ago. They are easy to scam through accounting fraud. When times get tough, the financial services industry demands (and usually receives) regulatory dispensation on flaky accounting, legalizing what would otherwise be blatant securities fraud.

U. S. banks are public/private partnerships, established for the public purpose of providing loans based on credit analysis. Supporting this type of lending on an ongoing, stable basis demands a source of funding that is not market dependent. All regulation, then, should proceed from a ‘public purpose’ standpoint and the regulatory focus should be on the asset side of the balance sheet. Banks should only be allowed to lend directly to borrowers, and then service and keep those loans on their own balance sheets. There is no further public purpose served by selling loans or other financial assets to third parties, but there are substantial real costs to government regarding the regulation and supervision of those activities. And there are severe consequences for failure to adequately regulate and supervise those secondary market activities as well.

Our key recommendations:

• Banks should not be allowed to have subsidiaries of any kind. No public purpose is served by allowing bank to hold any assets ‘off balance sheet.’ Banks should not be allowed to accept financial assets as collateral for loans. Forget about leverage ratios: no public purpose is ever served by financial leverage of any kind.

• Banks should not be allowed to buy (or sell) credit default insurance. The public purpose of banking as a public/private partnership is to allow the private sector to price risk, rather than have the public sector pricing risk through publicly owned banks.

If a bank instead relies on credit default insurance, it is transferring that pricing of risk to a third party, which is counter to the public purpose of the current public/private banking system. CDSs lead investors to be indifferent to a bankruptcy, and in many cases to push for it. Since they own a CDS, they will get their payoff, while negotiating a restructuring takes time and money. Why bother if you can collect immediately via the profits proceeds of a credit default swap? These “Frankenstein” products by all rights ought to be banned outright, but the most the Obama/Geithner reforms dare to propose is a clearinghouse system to reduce potential knock-on effects (systemic risk) from the failure of a large player. But the riskiest products are not standardized enough for a clearinghouse and therefore remain exposed to bilateral counterparty risk which regulators want to mitigate by imposing higher capital charges and disclosure of aggregate position holdings. Naturally, Wall Street opposes this.

The FDIC should be directed to examine the books of the largest insured banks to uncover all CDS contracts held. The gross positions should be netted out amongst these financial behemoths, canceling CDS contracts held on one another. CDS contracts with foreign banks should be unwound; the American taxpayer should not be in the business of bailing out non-US banks. In its examination, the FDIC will have to determine which of these banks are insolvent based on current market values-after netting positions. Those that are insolvent will be resolved. The ultimate objective must be to minimize the cost to FDIC and minimize impacts on the rest of the banking system. It will be necessary to cover some uninsured losses to other financial institutions as well as to equity holders (such as pension funds) arising due to the resolution. And finally, the Treasury and Fed will be directed to work to reduce concentration of the financial sector by avoiding resolution methods that favor large institutions. There will be a bias toward rescue of smaller institutions, and use of the resolution process to break-up the larger institutions.

The past few months have provided ample demonstration that Wall Street intends to recreate the conditions that existed in 2005. And make no mistake, the current situation is worse than it was in 2007 before the collapse, particularly in relation to large, systemically-significant financial institutions. President Obama, Fed Chairman Bernanke and Treasury Secretary Geithner have made many bold claims about their new financial reforms, but these reforms in no way represent a radical shift in its framework of analysis and policy implementation. The reality all three of them continue to turn a blind eye to the underlying problems in the hope that these will not return and blow up again on their watch. This is precisely the recipe for disaster followed by Alan Greenspan, Robert Rubin, and Henry Paulson.