Like most people who are suffering through this recession because of the truly spectacular avarice of the top 5% of income earners, I’m really, really interested to see what sort of power the US government even has to prevent such rigged, distorted markets from reoccurring and f*cking us all in the collective ass again.
Felix Salmon of Reuters believes that it doesn’t matter what regulations happen or don’t happen, we’re all doomed. He quotes Clay Shirky (talking about big media institutions, but argues the same holds true for big financial institutions) that, “Complex societies collapse because, when some stress comes, those societies have become too inflexible to respond”… and points out that in regards to the financial system, “We have reached a level of institutional complexity which renders radical simplification impossible, short of outright collapse.”
Salmon is probably right – he’s a particularly smart and astute financial commentator that I recommend you follow if you’re interested in business – but what’s wrong with this picture apart from overwhelming systemic complexity, and what options are on the table for fixing?
It’s going to take big balls to take on the financial industry
Part of the problem seems to be that that major banks of Wall Street operate as a cabal to fend off any regulation before it even hits the debating chamber. (That would be JP Morgan Chase, Bank of America, Goldman Sachs, Citigroup, and Morgan Stanley who together held 80% of America’s derivatives risk and 96% of the exposure to credit derivatives as of July 2009).
The Naked Capitalism blog suggests this cabal is preventing fancy financial instruments like derivatives (basically financial bets that are derived from other financial products i.e. bonds, currencies, interest rates etc, that leverage the returns from the underlying gains or losses) from being forced onto clearing exchanges. Clearing exchanges force financial institutions to underwrite their trades, with lower capital ratios that substantially reduce their leveraging capabilities and inhibit their ability to take the riskier bets – and consequent profits.
Leverage is financially speaking, the ability to use other people’s money as if was your own. The ability to leverage is fundamentally what makes financial services workers rich. It’s how you get the return on say, $30 invested when only $1 of that amount is actually yours. Leverage is a raw form of power.
So get this – this cabal of too-big-to-fail banks are using the TARP bailout funds they ostensibly received to prevent their implosion; to now lobby (i.e. pay) the Obama administration away from regulating the very transactions that helped drive them to collapse. The, ‘It’s cool, we can totally regulate ourselves, here, take this generous campaign contribution’ strategy. Chutzpah doesn’t begin to describe this.
Some economists think that given the catastrophic loss of jobs and wealth these mega financial institutions have wreaked upon the entire globe, we should just break them up. Too big to fail = too big full stop. Professor Robert Reich amongst others, points out that economies of scale basically disappear once a bank’s assets exceed $100 billion. So we should set that amount as the limit that banks can grow to, he argues, which would also inhibit their political leverage over politicians to rig the rules in their favor. For context, Goldman Sachs currently boasts total assets of $US849 billion.
Kevin Drum of Mother Jones however, isn’t entirely convinced by this argument. He points out that most of the institutions that caused the most trouble during the financial meltdown wouldn’t have been affected by an asset cap – either because they were too small (Lehman Brothers & Bear Stearns) or were outside such a mandate because they were insurance companies like AIG & Countrywide, non-bank financial entities, or they were government sponsored enterprises like Fannie Mae and Freddie Mac.
What’s more important than breaking up the mega-banks, is limiting all major financial institutions’ ability to leverage, reckons Drum. As Ezra Klein points out in Newsweek, banks’ capital ratios are set in such a way that they are able to lend out roughly $30 for every dollar they actually have in their coffers, so it makes a lot of sense to limit that leveraging ratio down to 15-1.
Leverage that high does a few things: First, it gives the bank more money to take risks, which banks like because it means higher profits. Second, it means that the bank has less money to pay back creditors if a bunch come calling at once, making failure more likely. Third, it means that if the bank does go down, it does more damage to the system because there are more people counting on the bank’s paying them back.
But then banks are only part of the problem – you’ve also got all the other non-bank financial entities that make up the ‘shadow banking industry’. They don’t take depositors’ money, but they do lend to businesses and institutions. Think pension funds, hedge funds and investment banks like Lehman Brothers and Bear Stearns.
Because they don’t take deposits they’re subject to very little regulation at all, and are an increasingly major source of credit in the global financial system. As former Federal Reserve Chairman under presidents Carter and Reagan Paul Volker suggests, re-instituting a modified Glass-Steagall Act (that southern Republican Senator Phil Gramm removed via deregulation in 1999) would mean that banks can either take deposits, or be part of the shadow banking system, but not be both. This action alone would substantially reduce catastrophic systemic financial risk.
I also think that Harvard economics professor Greg Mankiw has a great idea for getting rid of the substantial moral hazard that besets the financial system. Now that these private banks have been bailed out with public money, they really have little incentive to limit the risky behavior that got them (and us) into this mess, and every incentive to make even riskier bets because a) reward is proportionate to risk, and b) because they’ve now been deemed ‘too-big-to-fail’ by government, it doesn’t matter how big a hole they dig for themselves via failed financial speculation because they’ve effectively been guaranteed access to public money to cover their losses.
Writing in the New York Times Mankiw worries that one thing we cannot do very well is “regulate financial institutions”, although we should certainly try. He agrees that “higher capital requirements would be a step in the right direction” but goes on to point out that:
Whatever we do, let’s not be overoptimistic about how successful improved oversight will be. The financial system is diverse and vastly complicated. Government regulators will always be outnumbered and underpaid compared with those whose interest it is to circumvent the regulations. Legislators will often be distracted by other priorities. To believe that the government will ever become a reliable watchdog would be a tragic mistake.
The elegant solution that Mankiw proposes is this: he suggests we require not only banks, but a broad class of financial institutions (such as say, hedge funds and insurance companies) to sell contingent debt that can be converted to equity when a regulator deems that these institutions have insufficient capital.
This debt would be a form of preplanned recapitalization in the event of a financial crisis, and the infusion of capital would be with private, rather than taxpayer, funds. Think of it as crisis insurance.
Bankers may balk at this proposal, because it would raise the cost of doing business. The buyers of these bonds would need to be compensated for providing this insurance.
But this contingent debt would also give bankers an incentive to limit risk by, say, reducing leverage. The safer these financial institutions are, the less likely the contingency would be triggered and the less they would need to pay for this debt.
It sounds brilliant to me: if these racketeers get in trouble again they give up stakes in their ownership. Surely an extremely strong incentive to act with greater prudence. I’d love to hear the arguments against this from any economists, bankers, and accountants out there.
Ultimately we need to ask – is financial innovation a good thing?
It’s currently taken as a truism that it is. It’s taken as dogma that what benefits the stock market flows on to benefit the rest of society. Because increasing the various ways we can play with capital – other people’s money – benefits society by increasing entrepreneurs’ access to funds, and their ability to take risks and innovate, which ultimately creates more and better paying jobs for all of us.
Writing for the Washington Post, Ezra Klein challenges that assumption. He points us towards a new paper by economists Nicola Gennaioli, Andrei Shleifer, and Robert Vishny that warns that “financial innovation” actually leads to financial crises.
Most financial reform proposals accept financial innovation as a good thing and just try to protect against meltdowns, generally by controlling leverage and making it easier to dismantle failed bans. The model in this paper presents a different view: The boom-and-bust cycle of financial innovation is a risk to the economy, and thus “it is not just the leverage, but the scale of financial innovation and of creation of new claims itself, that might require regulatory attention.”
As a layperson, I’m just trying to make sense of all this, and would love input from those readers that have more experience in this field, both as to economic or regulatory prescriptions, as well as the political environment that would constrain or allow them.