(This is a guest post from Credit Writedowns.)
This morning I attended a breakfast on financial reform hosted by the Agenda Project’s Erica Payne. The purpose was to crystallize the issues most pertinent to the financial reform debate in these crucial weeks leading up to full Senate consideration and a likely Republican filibuster.
The Robespierre Moment
Leading the charge were Raj Date, Bob Pozen and Simon Johnson, all well-regarded financial experts who did a very good job of outlining the important issues.
Johnson, in particular, positioned himself as a moderate technocrat who, while calling for radical reform, sees himself as very far from extreme. He worries that we will see much more “dangerous” kinds of populism down the line if reform is not done correctly right now.
I would call this Simon Johnson’s Robespierre moment i.e. “If you politicians and bankers don’t listen to Johnson now, you will see the pitchforks come out when the modern-day Robespierre and his band of Jacobins take control of the reform agenda after economic collapse.”
The key consideration is this: how can the U.S. reform financial regulation to foster an efficient allocation of capital to its best uses via a well-functioning and safe financial sector. This is an issue both of the mechanisms and channels through which our financial sector operates as well as of the types and roles of financial institutions.
Most important in this debate is the safeguarding of both bank depositors and taxpayers who have suffered large losses in terms of lost interest on savings and lost economic output – sums far greater than the direct cost of bailouts.
The breakfast was only an hour. So, it wasn’t comprehensive. But, the issues which the panel covered included:
- Mechanisms for safeguarding deposits like increasing capital requirements
- Need for financial institutions over $100 billion in assets that become too big to fail institutions
- Cross-border resolution authority of large multi-national financial institutions
- Separation of public and private purpose of the government sponsored entities
Vampire squids and all that
As I left for the conference, I chatted with a friend who is far from the financial sector. Her take puts this debate into perspective. The issues are pretty easy to understand:
We have had an economic crisis the likes of which we haven’t seen since the Great Depression. People are still losing their jobs and homes as a direct result of the boom and bust caused by the financial sector. Yet, we have bailed the banks out with taxpayer money and the bankers act like they never needed the bailout, didn’t cause the crisis or some other ridiculous argument of that ilk. In fact, they are rewarding themselves with huge bonuses while everyone else is till in a world of hurt.
Forget about whether these arguments make any sense. They don’t. The only thing ordinary Americans need to know is that these people are paying themselves obscene amounts of money while everyone else is suffering despite the fact that we bailed them out of the crisis they caused. That’s the pitchfork thesis in a nutshell. All of the other stuff is a sideshow. Johnson confirmed that this is exactly what people have been telling him in his book signings all across America.
To my mind, this is what the Goldman fraud case is all about. Do you think the political payoff would be as high for going after JPMorgan Chase? Goldman is the vampire squid in mainstream America’s eyes and the Feds know this. That is why they have been targeted. However, remember that this is a civil case of a mid-level employee. This is not a criminal case. No bigwigs have been charged. So, we will have to see whether this is pure politics or something more. At a minimum, it sounds like the SEC is probing other cases at other firms.
As an aside, I should note that the last time we had scandals of this nature on Wall Street, Goldman Partner Robert Freeman was implicated for acting on a single comment “I think your bunny has a good nose.” The comment was seen as insider trading for its obvious reference to Bunny Lasker. Many believe Goldman threw Freeman under a bus to save itself the further scrutiny of Rudy Giuliani. This time around things will be different I suspect. Goldman had profits of $4 billion in 2007 as UBS, Merrill and Citi were haemorrhaging losses. This is in no small part to the efforts of the Fabulous Fab Tourre and his colleague Jonathan Egol (see NYTimes story here).
Getting from here to there: what’s impossible
So how do we avoid Simon Johnson’s Robespierre moment? It won’t be easy.
For one, the talk of re-instituting Glass-Steagall is a fantasy. Nouriel Roubini has said the Broker/Dealer business model is dead for just the reasons we witnessed in 2008 when their reliance on interbank money via certificates of deposit was fatal (think Bear Stearns, Lehman). Even Northern Rock succumbed because of excessive reliance on the interbank market for funding. So that’s a dead parrot business model.
Then, there is the issue of increasing capital requirements. Bob Pozen talked about Basel III rules requiring 10-12 per cent capital for all banks. But, Pozen says Lehman had over 11% in capital under Basel rules before it failed. Johnson is talking about 20-25% capital requirements. But, that is a political non-starter in Europe. Do you think German institutions, with their loan exposure to heavily indebted Mittelstand companies, can withstand that kind of regulatory capital requirement? The Europeans would never go for this. These kinds of capital requirements are a non-starter politically.
Equally problematic is resolution authority. We need to give the FDIC resolution authority. It is really about giving the FDIC the legal authority to seize and wind down a financial institution which threatens the US financial system. Even Jamie Dimon, Sheila Bair and Peter Sands understand this. However, the debate on resolution authority has become politicized. It’s not about ‘bailout out’ anyone as you might here in anti-reform propaganda.
While US resolution is necessary and doable, international resolution authority is a pipe dream. The UK-Netherlands-Iceland acrimony regarding Icesave tells you this. What Pozen feels we should do is proceed on with US resolution authority and then push for international resolution authority afterwards rather than trying to just hash out the international bit now since that’s never going to happen.
Moreover, resolution authority doesn’t really solve the problem of what Raj Date calls the Killer G’s: Goldman, the GSEs, GE Capital and AIG. These institutions are outside of the FDIC’s regulatory umbrella. Moreover, Johnson noted the increasing derivatives risk inside of non-financial businesses in the U.S., which poses yet another problem (and suggests a need for serious derivatives regulation reform).
Getting from here to there: what’s achievable
On the other hand, there are a few things that are doable.
First, there is Fannie and Freddie. I have said they serve no real public purpose and should be liquidated. All of the panellists agreed that the GSEs are a problem and that separating the public purpose (subsidy for low-to-moderate income housing) from the rest of what Fannie does would be advisable and achievable.
Bob Pozen was keen on requiring financial institutions to have a lot of subordinated debt on their balance sheets, something the other panellists also supported. Even I acknowledged that stuffing bondholders of the secured variety in a liquidation or bailout of a too-big-to-fail firm invites debt revulsion.
Hank Paulson mentioned in his book on the credit crisis that the Chinese called him when Fannie and Freddie were nationalized threatening retaliation unless they were made whole for their GSE paper (see my August 2008 post “Quote of the day: China hopping mad about GSEs“).
To avoid similar outcomes, Date says it does make sense to have subordinated bondholders who stand to take a significant haircut as a monitoring service to impose discipline on the allocation of capital at financial institutions. The price of this debt alone will serve as a data point for regulators regarding poor lending practices.
There was a surprising amount more which Pozen, Johnson and Date discussed in the hour, but I am going to leave it there.
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