Financial Regulation--Mistakes Made and A Path Forward

Financial Regulation—Mistakes Made and
A Path Forward

By Bill Breakstone
October 23, 2009


Only fools don’t learn from their mistakes. Is that how the saying goes?

Wednesday’s New York Times contained a front page article about Paul A. Volcker, former Chairman of the Federal Reserve Bank and currently the head of President Obama’s Economic Recovery Advisory Board. I skimmed the article briefly at first, and then re-read it carefully.

Much later that evening, I viewed the PBS program “Frontline,” an hour-long story about Brooksley Born, former head of the Commodity Futures Trading Commission, who resigned under pressure in 1999, and foresaw the coming financial collapse. She and her staff tried unsuccessfully to reign in the renegades on Wall Street who had created a multi-hundred-trillion-dollar market in derivatives trading, and who were totally unregulated and unrestricted under any securities laws.

First, the Volcker story, excellently written by The Times Louis Uchitelle. Here are some excerpts:
“Mr. Volcker (he is 82) has some advice, deeply felt. He has been offering it in speeches and Congressional testimony, and repeating it to those around the president, most of them young enough to be his children.
He wants the nation’s banks to be prohibited from owning and trading risky securities, the very practice that got the biggest ones into deep trouble in 2008. And the administration is saying no, it will not separate commercial banking from investment operations.”
“Mr. Obama has in Mr. Volcker an adviser perceived as standing apart from Wall Street, and critical of its ways, some administration officials say, while Timothy F. Geithner, the Treasury secretary, and Lawrence H. Summers, chief of the National Economic Council, are seen, rightly or wrongly, as more sympathetic to the concerns of investment bankers.
For all these reasons, Mr. Volcker’s approach to financial regulation cannot be just brushed off — and Mr. Goolsbee, speaking for the administration, is careful not to do so. “We have discussed these issues with Paul Volcker extensively,” he said.
Mr. Volcker’s proposal would roll back the nation’s commercial banks to an earlier era, when they were restricted to commercial banking and prohibited from engaging in risky Wall Street activities.
The Obama team, in contrast, would let the giants survive, but would regulate them extensively, so they could not get themselves and the nation into trouble again. While the administration’s proposal languishes, giants like Goldman Sachs have re-engaged in old trading practices, once again earning big profits and planning big bonuses.
Mr. Volcker argues that regulation by itself will not work. Sooner or later, the giants, in pursuit of profits, will get into trouble. The administration should accept this and shield commercial banking from Wall Street’s wild ways.
“The banks are there to serve the public,” Mr. Volcker said, “and that is what they should concentrate on. These other activities create conflicts of interest. They create risks, and if you try to control the risks with supervision, that just creates friction and difficulties” and ultimately fails.
The only viable solution, in the Volcker view, is to break up the giants. JPMorgan Chase would have to give up the trading operations acquired from Bear Stearns. Bank of America and Merrill Lynch would go back to being separate companies. Goldman Sachs could no longer be a bank holding company. It’s a tall order, and to achieve it Congress would have to enact a modern-day version of the 1933 Glass-Steagall Act, which mandated separation.
Glass-Steagall was watered down over the years and finally revoked in 1999. In the Volcker resurrection, commercial banks would take deposits, manage the nation’s payments system, make standard loans and even trade securities for their customers — just not for themselves. The government, in return, would rescue banks that fail.
On the other side of the wall, investment houses would be free to buy and sell securities for their own accounts, borrowing to leverage these trades and thus multiplying the profits, and the risks.
Being separated from banks, the investment houses would no longer have access to federally insured deposits to finance this trading. If one failed, the government would supervise an orderly liquidation. None would be too big to fail — a designation that could arise for a handful of institutions under the administration’s proposal.
“People say I’m old-fashioned and banks can no longer be separated from nonbank activity,” Mr. Volcker said, acknowledging criticism that he is nostalgic for an earlier era. “That argument,” he added ruefully, “brought us to where we are today.”
“He may not be alone in his proposal, but he is nearly so.”
“Still, a handful side with Mr. Volcker, among them Joseph E. Stiglitz, a Nobel laureate in economics at Columbia and a former official in the Clinton administration. “We would have a cleaner, safer banking system,” Mr. Stiglitz said, adding that while he endorses Mr. Volcker’s proposal, the former Fed chairman is nevertheless embarked on a quixotic journey.”

With this current news story as a backdrop, the excellent PBS show, “The Warning,” carried an impact that to this viewer was overwhelming, and maddening.

Brooksley Born graduated from Stanford University and Stanford University Law School at the top of her class in the mid-1960s, and was Editor of The Stanford Law Review. She was the first woman in Stanford’s history to attain such honors. One of her classmates was our former Supreme Court Justice Sandra Day O’Connor.

Born was appointed by President Clinton in 1997 to head the Commodities Futures Trading Commission (CFTC), an independent Federal regulatory agency created under Congressional authority. She soon became aware of how quickly the over-the-counter (OTC) derivatives market was growing, and how little any of the Federal regulators knew about it. “We had no regulation. No federal or state public official had any idea of what was going on in those markets, so enormous leverage was permitted, enormous borrowing. There was also little or no capital being put up as collateral for the transactions. All the players and counterparties to one another’s contracts. This market had gotten to be over $680 trillion in notational value as of June 2008 when it topped up. I think that was a peak. And that is an enormous market. That’s more than 10 times the gross national product of all the countries of the world.”1

“First of all, we really didn’t know the dangers in the market because it was a dark market. There was no transparency. But in any financial market, if there is not government oversight to control abuses like fraud and manipulation, to limit speculation, to make sure that a major default won’t cause a domino effect throughout the economy, the public interest is exposed and in danger.” The previous year, suit was brought by Proctor & Gamble (P&G) and Gibson Greeting Cards against Bankers Trust, their OTC derivatives dealer, alleging fraud, a suit won by the plaintiffs. There had also been some spectacular failures, collapses from speculative dealings of fund managers at public institutions acting with similar derivatives dealers, notably the Pension Fund of Orange County, California, which was forced into bankruptcy because of its speculation, gambling with public money in the OTC derivatives market on interest rate swaps. In that case, every taxpayer in Orange County suffered the consequences.

Berksley Born was the Chair of this regulatory agency, the CFTC. She, rightly, perceived one of her responsibilities as defending the public interest. There was something definitely wrong about these markets. There was no record-keeping requirement; no reporting. Now keep in mind that this was 1997, a full decade before the financial collapse that we are still recovering from.

Born and her staff thus prepared a paper on the subject called a “concept release” [a report to be released to the public outlining a proposed rule change], in this case asking questions about the market, whether certain changes needed to be made to the regulatory regime; whether there need to be record-keeping; should there be reporting requirements to some Federal regulator; would clearing the transactions in a clearinghouse help protect against counterparty risk of default by one side or another?

When word of this proposed release reached the government, in the persons of Treasury Secretary Robert Rubin, Fed Chairman Alan Greenspan, and SEC Chair Arthur Levitt, all hell broke loose. In a meeting set up in Greenspan’s office, Born was told a report of this nature would be catastrophic to the financial markets, which at the time were operating smoothly and churning out record profits. Born was shocked. Was fraud to be permitted, sanctioned at the highest levels of government due to a straightjacket ideological approach to market self-regulation?

Despite the warnings of Greenspan, et al, the CFTC went ahead and published the concept release in May of 1997. Eventually, Congressional hearings were held, and a six-month moratorium at first imposed on the CFTC from taking any action, which was further extended indefinitely.

Some two years later, the hedge fund Long Term Capital Management collapsed, causing near-panic on Wall Street and a crisis that was averted only because the Fed and Treasury pressured a dozen or so of the largest investment houses to fund its rescue by an infusion of hundreds of millions of dollars in capital. Sound familiar?

The bottom line was that these OTC “black markets” were allowed to go on in a business as usual mode, with no regulatory changes made. In fact, a statute was passed in 2000 called the Commodities Futures Modernization Act [CFMA] which specifically took away all jurisdiction over the OTC derivatives market from the CFTC. Born resigned in 1999, and the rest is history.

Could the financial collapse of 2007-2009 been prevented by bringing light to a market that was completely unregulated and unknown by market participants and counterparties? Probably not, but the damage would have been contained somewhat. The collapses of several investment houses may have been avoided, but other factors were acting on the economy, the bursting of the housing bubble, the evaporation of the public trust in the markets without which public and private finance cannot thrive, the subsequent collapse of consumer confidence and spending, and the worst unemployment rate in over 35 years.

So, where are we now? Financial regulation is a main topic in today’s news, the Volcker story just one example. What are the odds that safeguards will be put in place to avoid a repetition of the recent financial disasters? The major players on the stage back in 1998, with the exception of Rubin, have all submitted their “mea culpa’s.” Yet the financial industry’s lobby is putting up a terrific fight to preserve its self-interest.

Born was asked if this moment passes [without such regulation], what will be the consequences from your perspective? She answered “I think we will have continuing danger from these markets and that we will have repeats of the financial crisis. It may differ in details, but there will be significant financial downturn and disasters attributed to this regulatory gap over and over until we learn from experience.”

One final cautionary note from Nobel Prize Winning Economist Joseph Stigliltz:

“So this is a dangerous moment, because if we don’t get it right, we are likely to wind up with an even more politically influential financial system, banks that are even bigger, more too big to fail, too big to be financially resolved, and so the risk of another crisis some years down the line is going to be greater. The risk that our economy’s performance will be weaker, the risk that there will be greater inequalities and a sense of injustice in our society will be higher.

So I think this is really a moment. I was very hopeful that in the aftermath of the crisis we could see what had gone wrong and say “Let’s fix it.” But it may be that we are passing that critical moment.”



1 Quoted material in this article is from interviews with the participants, and can be found on-line at http://www.pbs.org/. Go to “Frontline” to view the numerous interviews.