Financial Reform

by Bill Breakstone
Somers, New York, Sunday, May 2, 2010

There have been dozens of books, articles and op-ed pieces written about the recent financial crisis and current efforts to insure against a repeat of it.

There were numerous failures that brought our economic catastrophe. Although I have spent hundreds of hours of study over the past year trying to gain a better understanding of the underlying reasons for our plight, I am not an economist, nor a professional economic writer. But I believe I have learned quite a bit, and given the timing, with the economic reform legislation now being debated on the floor of the Congress and in the media, now might be a propitious moment to briefly summarize past causes and future options.


CAUSES:

Financial De-regulation. Starting in the 1970s, economic academia began to whittle away at Keynesian theory and over a three decade period championed and elevated economic self-regulation to the forefront. In the process, the safeguards that were built into the system after the experience of the Great Depression were repealed, and the role of government regulators diminished almost entirely.

Corruption of the Incentive Structure. With the disappearance of barriers between commercial and investment banking, and the resultant allowance proprietary investing, major financial players became more and more focused on profits, and profits resulted from a huge increase in creative financing, where results were based upon smaller margins but hugely increased volume, so that real results (i.e., gains or losses) were subordinated to making the deals.

Conflicts of Interest in the Ratings Industry. As The New York Times lead editorial focused on this morning, rating agencies were, and still are, hired by the creators of financial instruments to place a guidance regarding the quality of those instruments. They compete for business with their competitors, while the issuers can play them off one against the other for the business they need to survive and profit. This conflict resulted in the surrender of whatever fiduciary responsibility they were committed to. At the same time, GSEs (government-sponsored enterprises, i.e., Fanny & Freddie) were allowed to market non-conventional instruments (mortgages) with greatly reduced oversight as to qualifications and equity down payments.
Regulatory Ineptitude. The regulators that survived the “purge” almost totally ignored the warnings that were raised, whether concerning a derivatives market that grew completely out of control, or cases of fraud that several honest and diligent officials tried to bring to their attention. As a final affront, political and economic leaders (of both ideological persuasions) passed laws that denied those same regulators from taking the necessary steps to create transparency in those markets.

Decreased Competition and the Creation of Financial Oligarchies. The idea that bigger was better became the prominent philosophy in the financial industry. Institution after institution was merged into former competitors creating mega-banks, and then these mega-banks gobbled up lender after lender. The end result was a decrease in effective competition, and the creation of colossal institutions, the failure of any that might bring the whole system crumbling down. And this in fact was what happened when the housing and credit bubbles burst.


FINANCIAL REFORM OPTIONS

Too Big To Fail. So much has been written on this subject, most of it terrifying in its creation and fascinating in its results. What is certain is that the creation of these oligarchies, with their immense financial resources and lobbying capabilities, must be whittled down to a size where the failure of one or more threatens to bring down the entire world economy.

Even leading bankers, such as Jamie Dimon of JPMorgan Chase has agreed to this, when he said in The Washington Post on November 13, 2009: “The term too big to fail must be excised from our vocabulary.” Alan Greenspan and his reliance on free-market ideology suffered a comeuppance truly remarkable in the history of economic theory, but Simon Johnson gives credit to him for one afterthought, when the former Fed Chair stated in a lecture to the Council on Foreign Relations on October 15, 2009: “If they’re too big to fail, they’re too big. I—this one has got me. And the reason it’s got me is that we no longer have the capability of having credible government response which says, henceforth no institution will be supported because it is too big to fail.” What he means is that the interconnectedness of financial institutions and the investment vehicles they created pose a danger that forces the rescuer of last resort to do that which it abhors, and that is to create what has been called a moral hazard.

Three Possible Solutions. It will take time to enact policies to address the causes of the current crisis. We are making a start now, but no one should be so naïve to believe that the proper changes will happen overnight. Anti-trust legislation took a decade to take hold in the first decade of the Twentieth Century. But we must set out on a course that over time will achieve the protective results to prevent another meltdown.

Thus, here are three initial starting points, as suggested by Johnson and Kwak in their current book “Thirteen Bankers”: First, impose a hard-cap limit on the size of financial institutions. “No institution would be allowed to control or have an ownership interest in assets worth more than a fixed percentage of U.S. GDP . . . . the percentage should be low enough that banks below that threshold can be allowed to fail without entailing serious risk to the financial system.”

Second, institute enhanced capital requirements within these institutions. One of the triggers of the recent meltdown was the off-balance-sheet status of the huge derivative markets, thus eliminating them from capital requirements that would have gone a long way to lessen the impact of their diminution in value to junk status from where the rating agencies had valued them (incredibly, through alchemy that made Merlin look like a three-bit performing magician at the Podunk State Fair) as AAA securities.

Finally, third, regulatory bodies have to maintain a far higher level of professionalism and prudential oversight. To do this, they must be legislatively empowered on the one hand, and given the financial and human resources to accomplish their mission successfully.

Johnson and Kwak begin and end their book with references to the ideological conflict between Thomas Jefferson, who feared concentrated Federal power, and Alexander Hamilton, who believed in a strong central banking system. They conclude: “Even when it goes out of fashion, Thomas Jefferson’s suspicion of concentrated power remains an essential thread in the fabric of American democracy. The financial crisis of 2007—2009 has made Jefferson a little less out of fashion. It is that tradition of skepticism that, if anything, can shift the weight of public opinion against our new financial oligarchy—the most law-abiding, hardworking, eloquent, well-dressed oligarchy in the history of politics.”