There is an effort underway to install the Federal Reserve as super-regulator for all banks and financial institutions, concentrating power in one institution. I find these efforts one of the most disturbing outgrowths of the financial crisis we have been witnessing. Such a system is sure to increase the power of too big to fail financial institutions and weaken small community banks. Moreover, the Federal Reserve is the one institution which should not take on a greater role in the U.S. economy. It has failed in its present role by pushing interest rates too low for too long and has shown a complete lack of regulatory courage in preventing excesses that resulted from this policy.
The Obama Administration as defenders of the status quo
The Obama Administration is at the front of the queue advocating for this line of regulatory reform. In my view, this has weakened the Administration, as the American people have grown to distrust the Federal Reserve as witnessed by the broad support for the Federal Reserve Transparency Act of 2009 proposed by Ron Paul to audit the Fed (H.R. 1207).
It is clear to most everyone now that actions taken by the Federal Reserve led to excessive risk taking in the financial services industry, particularly by large institutions. The risk posed by these institutions is what brought the global financial system to the verge of collapse.
Why then has the Obama Administration been supporting large institutions through large bailouts without requiring any changes in leadership or compensation? Why is the Administration proposing to put the one regulatory institution most Americans feel failed in the period leading up to crisis in charge of all regulation? Do they not realize that this is an outrage to which the American people are wise? Do they not realize that this lessens any sense that Obama is ‘change we can believe in,’ hurting his chance at enacting legislation elsewhere?
Barack Obama was elected despite widespread concern about inexperience because he was perceived as a change agent who could demonstrate the power of government to do good in a time of crisis. Yet, the narrative now being crafted through these policy missteps is one of big government that enables the well-connected and powerful at the expense of the common man. This theme was evident with the financial bailouts. It was evident againregarding how differently the automakers were treated. And it is evident again in how much sway lobbyists have held in the healthcare debate.
So, Obama’s poll numbers have slipped. They are not down because he is running left and outsourcing his policy decisions to Congress as some might have you believe. Disaffection with the administration’s policies are as great in his base of supporters as they are from independents. Obama’s numbers are down because he campaigned as a man of change, but has governed as a defender of the status quo.
And when a country is beset by crisis and economic calamity, the status quo is not acceptable.
The attack of Sheila Bair
Enter Sheila Bair. She has not been toeing the party line on regulatory reform. She rightly sees a problem with having a super-regulator to fix the problems at the heart of the financial crisis. This has not sat well with the Administration. But, she has continued to be a dissonant voice, most recently in an Op-Ed which appeared this past Monday in the New York Times. Title? The Case Against a Super-Regulator.
The Obama administration has proposed sweeping changes to our financial regulatory system. I am an active supporter of the key pillars of reform, including the creation of a consumer financial protection agency and the administration’s plan to consolidate the supervision of federally chartered financial institutions in a new national bank supervisor. This consolidation would improve the efficiency of federally chartered institutions while not undercutting our dual system of state and federally chartered banks.
But some are advocating even more drastic changes, like the creation of a single regulator for all banks (and bank holding companies). We clearly need to streamline the system, but a single regulator is not the solution. Calls for consolidation beyond the administration’s plan fail to identify the real roots of last year’s financial meltdown. The truth is, no regulatory structure — be it a single regulator as in Britain or the multiregulator system we have in the United States — performed well in the crisis.
The principal enablers of our current difficulties were institutions that took on enormous risk by exploiting regulatory gaps between banks and the nonbank shadow financial system, and by using unregulated over-the-counter derivative contracts to develop volatile and potentially dangerous products. Consumers continue to face huge gaps in personal financial protections. We also lack a credible method for closing large financial institutions without inflicting severe collateral damage on the economy.
My translation of what Bair is saying
I would like to paraphrase here, if I could, because Bair is using the diplomacy of a high-ranking government official in order to get along. Reading between the lines presents another picture.
Translation:
Obama and his economic team have put together a decent first effort on regulatory reform. Let me list some stuff I agree with to be diplomatic. Below I get to what this Op-Ed is really about.
These people want to insert the Fed as the all-powerful financial regulator. Sure, we need change but not this kind of change. That’s why my title is “The Case against a Super-Regulator.” Makes sense? Other countries have a similar system to what Geithner and Summers are proposing. If you look around – at England or Germany, for example – these guys are not exactly covering themselves in glory.
The problem is not the regulatory structure, it’s unregulated financial institutions operating outside the regulatory umbrella and too big to fail institutions inside the umbrella taking on too much risk.
A better approach
So clearly, changing the placement of regulatory captains is irrelevant here. What is highly relevant is controlling excessive risk taking, especially by systemically important institutions as we saw with Citigroup in 1990, Goldman in 1994, Long-Term Capital Management in 1998, and Lehman and Bear Stearns in 2008.
In the past, the Federal Reserve has not been willing to rein in excessive risk taking. I would argue that its very function is to subvert market forces and encourage risk-taking by manipulating interest rates to achieve its dual goals of full employment and economic growth. Why should we expect an institution which lowered interest rates to 1% in order to encourage risk-taking and then refused to crack down on excesses this policy engendered to be the systemic risk regulator? It makes no sense.
This is the same institution which now has interest rates at 0% and has used all manner of credit easing mechanisms to foster credit growth and risk-taking as policy remedy to the present crisis. Should we expect that it will magically change tack, pivot 180 degrees and start cracking down on excessive risk-taking and systemic risk? This too does not seem logical. And I would be remiss if I didn’t point out the lack of transparency at the Federal Reserve as demonstrated by the lawsuit by Bloomberg LP under the Freedom of Information Act (I do think Bernanke has been more forthcoming about monetary policy decisions and is welcome change on that score).
Forget about instituting a whole new labyrinth of rules, regulations and regulators. This is what we did after 9/11 when the Department of Homeland Security was created – and that has not been successful. But, a Department of Financial Security (DFS) may be coming. Back in May 2008, well before Lehman collapsed, I predicted this would happen.
This means that the de-regulation era has effectively ended. Big mergers will be eyed suspiciously. The cost of doing business will increase as red tape and regulation increases. All of this is bad for anyone looking to make a boatload of money based on capital gains in a new bull market. I happen to think that the pendulum does need to shift substantially away from de-regulation, but this will certainly mean an end to inflated asset prices in the capital markets.
As far as regulation goes, I predict a ’super-regulator’ is in the offing a la the Department of Homeland Security (DHS). This bout of big government is going to produce a federal agency akin to DHS because people are going to want to see an all-powerful federal agency formed that can effectively keep the capitalist wolves at bay when they overreach. This is a transformation that I view with some dread because I believe that, while de-regulation had swung way too far, big government is a problem, not a solution.
My hope is that the Obama Administration will see a DFS as big government that people do not want. The writing is on the wall about ‘big government.’ We see it in the healthcare debate. This should serve as a warning to the Administration that any legislation it proposes cannot be seen as big government or it will fail. It is better to enforce the rules and regulations that are currently on the books than to build in a whole new super-structure.
I propose the following:
- Shelve any talk of a super-regulator. It is a dangerous idea that will prove both politically unpopular and ineffective.
- Enforce the regulations that currently exist. For example, anti-trust law should prohibit any institution from holding more than 10% of banking assets. Another example is the Home Owner Equity Protection Act of 1994, which gave the Federal Reserve the authority to stop abusive mortgage lending practices.
- Promote smaller community banks. The Bush and Obama Administration’s policies during this crisis have favoured big banks. Meanwhile, community banks are being held to a disadvantage in access to cheap capital. Why doesn’t the FDIC spin off seized assets as small community banks with new leadership instead of gifting them to private equity or other banks?
- Regulate OTC derivatives. Full-stop. No clearinghouses. No loopholes. We need an exchange-traded OTC derivatives market. (listen to the audio at the bottom of this post to hear how lobbyists gutted the OTC derivatives regulation in Obama’s reform package).
- Keep the Consumer Finance Protection Agency. If we want any new regulators, this is where we need them. The Fed failed to protect consumers from abusive mortgage lending practices and there is now a balkanized regulatory structure to oversee consumer protections. The CFPA would change this.
- Bring the shadow banking system into the regulatory orbit. This means regulating hedge funds and money market funds in addition to banks, thrifts, credit unions and brokerage houses.
Audio podcast with Bair
Sheila Bair is on the right track and I respect her taking her views public in a manner respectful of the Administration. Yesterday, she spoke to NPR about this issue in an hour-long radio Diane Rehm Show broadcast with Susan Page of USA Today. There were other guest panellists taking views in support of and against a super-regulator. Below is the audio from that show. I think the debate on this audio makes for good listening and will help inform your knowledge about this issue.