Is Financial Reform Already A Failure?


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Governments around the world appear to be losing their will to enact controversial reforms, Reuters is reporting.  As economies in the Europe and the US show signs of recovery–and the banking sector in particular seems to be booming–controversial changes seems less urgent. 

“The American regulatory structure is in total disarray and what has been proposed to fix it is partial, and even then there is heavy resistance,” Hal Scott, Nomura Professor on International Financial Systems at Harvard Law School, tells Reuters. “I don’t see us coming out with any significant change to the structure. The right rules and the wrong system is what we might end up with.”

Reuters’s Huw Jones characterises the problem as a lack of appetite for serious reform. But a close reading of his article suggests it’s not just appetite that is the problem–it’s also a knowledge problems. The would-be financial regulators just don’t know what to do.

There’s widespread agreement that financial institutions need to have a “living will,” some sort of blueprint for how they can be quickly wound-up if they fail. But no one really knows how this will work in practice, or if it is even possible. Sounds great in theory but may be hard to put in place in practice. In the first place, there’s almost no one in the world who knows how to do this effectively. We’d be inventing an entirely new branch of risk management.

U.S. Treasury Secretary Timothy Geithner has effectively called for the replacement of the Basel II set of rules favoured by European countries. The US was in the process of adopting those rules when the crisis struck. And now it is obvious that Basel II and its predecessor, Basel I, were inadequate at best and most likley contributed to the problems in banks by encouraging banks to hold too many securitized loans. But there is no Basel III waiting in the wings. No one is really sure what will come next.

Perhaps the good news from all of this is that we have not rushed headlong into structural reforms that might have created an illusion of safety without actually shoring up the financial system. The likelihood of bad regulation was increased by the misplaced feeling that the “lessons of Lehman were clear.”

“There is a strong consensus on core lessons learned from Lehman’s failure and the credit crunch,” Jones writes.

But what are those lessons?

The primary lesson appears to be the need to monitor risk across the financial system, not just within certain markets or at individual institutions. The thought is that this monitoring could reduce the risk across the financial system.

There’s little evidence for this proposition, however. The Fed, which was charged with monitoring systemic risk, was very late to recognise the trouble in the housing market. Indeed, Fed officials insisted until well into the crisis that real problems were unlikely. If bankers whose own wealth was tied up in the success of their banks failed to anticipate their problems, how exactly will bureaucratic monitoring agents uncover bubbles and systemic risk?

It seems far more likely that the systemic monitors in the US and Europe will fall prey to regulatory capture and be used by powerful financial institutions to gain advantage over less influential competitors. In fact, this is already happening. Wall Street banks are reportedly using the Obama administrations pay czar to prevent competitors from bidding up the cost of their best traders. And in Europe, banks and politicians are angling to protect domestic banks against foreign competition.


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