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The Three Essentials of Financial Reform
As the White House unveils its long-awaited proposals to prevent another Wall Street meltdown in the future, keep a lookout for three essentials. Without them the Street will revert to its old ways as soon as the coast clears. In fact, now that the government has bailed out the Street, the biggest banks will take even larger and more irresponsible risks because they’re officially too big to fail. So these three reforms are critical.
1. Stop bankers from making huge, risky bets with other peoples’ money. At the least, require they back their bets with a large percentage of their own capital, and bar them from raising money off their balance sheets through derivative trades. Also require they take their pay in stock options or warrants that can’t be cashed in for at least three years, so they’ll take a longer-term view. Best of all would be a requirement that investment banks return to being partnerships and the capital on their books be their own, not yours or your pension fund’s. When investment banks were partnerships, every partner took an active interest in what every other partner and trader was doing. The real mischief started once they started selling shares to the public.
2. Prevent any bank from becoming too big to fail. Separate commercial from investment banking, as they were before the late 1990s. Commercial banks should return to their basic function of linking savers with borrowers. Investment bankers should return to their casino function of placing bets in the stock market and advising you and others about where to place your own own bets. Combining the basic utility with the casino only made bankers far richer and subjected you and me to risks we didn’t bargain for. If separating commercial from investment banking isn’t enough to bring all banks down to reasonable size, use antitrust laws to break them up.
3. Root out three major conflicts of interest. (1) Credit-rating agencies should no longer be paid by the companies whose issues are being rated; they should be paid by those who use their ratings. (2) Institutional investors like pension funds and mutual funds should not be getting investment advice from the same banks that profit off their investments; the advice should come from sources without a financial stake; (3) the regional Feds that are responsible for much bank oversight should no longer be headed by presidents appointed by the region’s bankers; non-bankers should have the major say, and the regional presidents should have to be confirmed by the Senate.
These three reforms will reduce the possibility that you and I and other taxpayers will ever again have to spend billions bailing out bankers who robbed us blind while amassing fortunes. But because that would make it next to impossible to make such fortunes in the future, the big bankers will fight every one of these with all guns blazing, and their lobbyists in full force. They’ll try to inundate you in a blizzard of buzz words. They want your eyes to gaze over, but don’t let them. Keep focused on these three issues. Congress, for its part, may not be much help. It’s awash in money from Wall Street. Big Finance is second only to the health-industrial complex in owning a large portion of the Hill. Barney Frank at House Banking can be relied on to try his best but others in the House and Senate may well roll over. The President wants to do the right thing but he’s spread thin and spending political capital on health care. Tim Geithner doesn’t have the stomach to take on the Street; the plan he announced a few days ago to regulate pay is a bad joke. Expect lots of blather about rearranging boxes on the regulatory organization chart.
Bottom line: Genuine financial reform will be almost as difficult to achieve as real universal health care. Immense private interests are amassed against the public interest in both cases because staggering amounts of money are at stake. But they are the two most important domestic issues right now. Keep careful watch, and weigh in.
1. Stop bankers from making huge, risky bets with other peoples’ money. At the least, require they back their bets with a large percentage of their own capital, and bar them from raising money off their balance sheets through derivative trades. Also require they take their pay in stock options or warrants that can’t be cashed in for at least three years, so they’ll take a longer-term view. Best of all would be a requirement that investment banks return to being partnerships and the capital on their books be their own, not yours or your pension fund’s. When investment banks were partnerships, every partner took an active interest in what every other partner and trader was doing. The real mischief started once they started selling shares to the public.
2. Prevent any bank from becoming too big to fail. Separate commercial from investment banking, as they were before the late 1990s. Commercial banks should return to their basic function of linking savers with borrowers. Investment bankers should return to their casino function of placing bets in the stock market and advising you and others about where to place your own own bets. Combining the basic utility with the casino only made bankers far richer and subjected you and me to risks we didn’t bargain for. If separating commercial from investment banking isn’t enough to bring all banks down to reasonable size, use antitrust laws to break them up.
3. Root out three major conflicts of interest. (1) Credit-rating agencies should no longer be paid by the companies whose issues are being rated; they should be paid by those who use their ratings. (2) Institutional investors like pension funds and mutual funds should not be getting investment advice from the same banks that profit off their investments; the advice should come from sources without a financial stake; (3) the regional Feds that are responsible for much bank oversight should no longer be headed by presidents appointed by the region’s bankers; non-bankers should have the major say, and the regional presidents should have to be confirmed by the Senate.
These three reforms will reduce the possibility that you and I and other taxpayers will ever again have to spend billions bailing out bankers who robbed us blind while amassing fortunes. But because that would make it next to impossible to make such fortunes in the future, the big bankers will fight every one of these with all guns blazing, and their lobbyists in full force. They’ll try to inundate you in a blizzard of buzz words. They want your eyes to gaze over, but don’t let them. Keep focused on these three issues. Congress, for its part, may not be much help. It’s awash in money from Wall Street. Big Finance is second only to the health-industrial complex in owning a large portion of the Hill. Barney Frank at House Banking can be relied on to try his best but others in the House and Senate may well roll over. The President wants to do the right thing but he’s spread thin and spending political capital on health care. Tim Geithner doesn’t have the stomach to take on the Street; the plan he announced a few days ago to regulate pay is a bad joke. Expect lots of blather about rearranging boxes on the regulatory organization chart.
Bottom line: Genuine financial reform will be almost as difficult to achieve as real universal health care. Immense private interests are amassed against the public interest in both cases because staggering amounts of money are at stake. But they are the two most important domestic issues right now. Keep careful watch, and weigh in.
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Killing the Fed would do wonders to solve all three problems.
How does the free reign of the private, secretive, and unaccountable-to-anybody Fed escape your wise brain.
The Fed is owned by the big banks. Which banks? We can't be entirely sure, and you don't even seem to want to know to what overwhelming extent the "too big to fail" banks are actually regulating themselves, and bailing themselves out with our money when they do fail.
Nothing to see here, right Robert?
June 16, 2009 3:09 PM | Reply | Permalink
The Federal Reserve is a very peculiar entity, but I am curious: with what do you propose to replace it? If "nothing at all", who takes over some of the powers it has? (Someone has to run the printing press for the dollar, unless you propose to do away with the dollar too. While the presses are actually operated by the Bureau of Engraving and Printing, they are "run", as in directed, by the Fed, at the moment.)
June 16, 2009 4:59 PM | Reply | Permalink
Department of the Treasury?
June 16, 2009 8:11 PM | Reply | Permalink
At 0% interest, with Congressional and Executive oversight.
June 16, 2009 9:32 PM | Reply | Permalink
It's an interesting thought. That would put control of the money supply under the Executive. So we'd have funding (taxation) in Legislative (Congress), but monetary base (value of the dollar) in Executive. I think if one were going to do this, it might be wise to insert some sort of arms-length distancing though, similar to the way the Judiciary branch is supposed to be insulated from politics.
June 17, 2009 3:39 AM | Reply | Permalink
Changes in money supply -- that is, changes which result from the combination of, on the one hand, government expenditures ("printing" money) and, on the other, government receipts ("unprinting" money via taxes)-- would be, as they are today, under Congressional control.
The Executive only pays for what Congress authorizes and thus, only "prints" money sufficient to make those payments and of course, taxes (the cancellation/destruction of that printed money) are established by the Congress.
June 17, 2009 8:33 AM | Reply | Permalink
The real solution:
End legal tender laws, and allow people to demand payment in gold or silver.
June 17, 2009 11:37 PM | Reply | Permalink
3 great areas for regulation. However, if the Bush SEC could not discern that Madoff was running a Ponzi scheme after being tipped off that it was a scam and running a 2 year audit, can we trust regulators?
Is Geithner's plan just a mild tweak that the big money types can circumvent? Obama's plan seems like it may be just a rearranging of the roulette wheels in the casino.
Sending more than a few of these bankers to jail, or at least trying for indictments, might be the best medicine for the system.
June 16, 2009 3:56 PM | Reply | Permalink
Re SEC: Chris Cox was and is a dork.
June 16, 2009 8:07 PM | Reply | Permalink
I would also add regulating (or prohibiting) "pooling" instruments that are principally designed to dilute risk (e.g., CDOs, MBSs).
Markets work best when there are clear lines between risk and reward.
It also makes it faaaar easier to clean up the mess, after the music stops.
June 16, 2009 4:27 PM | Reply | Permalink
I think this is one of the key points. Diluting risks only seems to make them disappear. A teaspoon of toxic waste in a barrel of water is a barrel of toxic waste.
June 16, 2009 4:42 PM | Reply | Permalink
The separation of commercial banks from investment banks, with an accompanying prohibition of banks ever using any federally insured funds on those pooling instruments or the stocks and bonds issued by investment entities (of any kind or definition) who dealt in them should take care of what you are talking about. The investors who want to invest in those risky "assets" would then know what they were getting, especially if those investors also paid the rating agencies.
Then the commercial banks would not be running risks that could cause them to fail using insured (riskless) deposit-based funds. If the investment institutions failed, then the danger to the overall economy would be very much reduced.
I also think the rating agencies, acting for the investors, would protect their paychecks by making sure that they actually understood the risks in the pooling funds. The second point is that the institutions that created those funds would then have to sell not only the investment itself but also it's nature and security to individual investors and the rating agencies. A rating agency that made a mistake would find themselves unable to sell their services to investors.
Mortgage companies and banks themselves would also have to sell the competence with which they issued mortgages, or they would not be able to get funds to lend at any interest rate except in a few instances of individual investors with large sums of money who were willing to take massive risks on unrated investments.
That system would take much of the motivation to invest in high-risk instruments away from those who never should have been doing it in the first place. That was why the problems have centered a lot more on Wall Street banks than on regional banks.
These are just thoughts off the top of my head. Remember, I am not a banker or investment professional.
June 16, 2009 5:02 PM | Reply | Permalink
Push for those reforms.
Further, if the bailed out banks are too large to fail, it is the duty of the government to reduce size and influence by judicious breakups. I see dealing with companies that are too big and present a burden on the economy as government's responsibility. Remember the great burst of productivity following the breakup of the ATT monopoly. OK, I admit I am older than most of you. I was for it unlike those around me. The results were spectacular. Capitalism simply requires judicious pruning to keep it robust.
June 16, 2009 4:35 PM | Reply | Permalink
A good start but more is needed. Short selling. Futures markets. Currency speculation. There's lots more... We need the casino completely gone from our financial futures.
June 16, 2009 4:38 PM | Reply | Permalink
What will you do about the fact that buying and holding stock is risky, depending on the nature of the company, the economy and the products?
Lending is inherently even more risky, although there are a lot of things thrown into the contract that are designed to make sure the company pays the lender first before taking profits. Essentially the lenders reduce the risk of not getting paid back by skimming the most reliable income from the borrowers before those borrowers spend it anywhere else. (Note the complaints from lenders to the automotive companies about being put behind labor when the bankruptcy courts make their decisions.)But some products and companies simply have more risky future revenue streams, so they have less certain revenue that a lender can count on.
The bigger companies are less risky as companies because they spread the risk from individual buyers over all the buyers they service, and some products, like food and utilities, are going to be demanded no matter what the economy does. Big companies are like gambling casinos. They have a lot of risky input revenue streams but by the law of large numbers the overall revenue stream levels out and becomes quite reliable.
It's not a question of eliminating risk. You can't. It's a question of measuring foreseeable risk and making sure the anticipated revenue stream is probably going to be big enough to cover most bad situations that can be anticipated. Then, big companies by their very size are spreading the risk they took around to a lot of different revenue sources because they have a lot of customers.
June 16, 2009 11:30 PM | Reply | Permalink
The difficulty with "Credit-rating agencies should no longer be paid by the companies whose issues are being rated; they should be paid by those who use their ratings." is how to enforce it. Suppose I'm in the market for bonds, and I want to put my money into a highly rated bond. The fact that, say, Moody's, has rated some company's corporate debt highly is going to be widely available information.
June 16, 2009 4:39 PM | Reply | Permalink
Is there any kind of advocacy group taking the initiative in backing these kinds of reforms?
For civil liberties, there's the ACLU, among others. Why not an American Financial Liberties Union, if one doesn't already exist? After all, one of our chief liberties - the pursuit of happiness - doesn't mean much if you don't have a safe haven for your nest egg.
June 16, 2009 5:43 PM | Reply | Permalink
How about eliminating fraud and punishing the fraudsters? (Note: these people should be put in jail but they are currently running the show in Wall Street , the Fed and the Treasury Dept.)
Here's how straw was turned into gold and sold to rubes the world over:
How easy is it for the big timers on Wall Street to take your hard earned money? Let us count the ways. The biggest scam ever was the subprime mortgage business (1). Credit was so easy (2) that anyone with a pulse (3) was given a junk mortgage, these, in turn, were shoveled through the doors of the banks and insurers like AIG (4). Next, our best and brightest bankers prevailed (5) upon the rating agencies to label the junk as AAA securities. These “troubled assets” were then sliced and diced, securitized , leveraged 30x and sold around the world as if they were gold (6). The business was such a money machine that it was impossible to say no to it. When the housing bubble burst, people lost their life savings, and countries went down. (Take particular notice of the "securitization" part. This is the way they turn junk into gold. They can do this any day of the week, including Sundays: beware when Madoff or Summers knocks on your door!)
Capitalism has finally developed its own economic weapons of mass destruction: cdo's, quants, credit default swaps, securitization, mega-million dollar salaries. Combine this with the usual greed, fraud and avarice and you have a killer system. Except it will kill itself.
June 16, 2009 6:03 PM | Reply | Permalink
Not if Obama and Geithner have anything to say about it!
Hedge funds just had one of their best months ever and bank profits are soaring.
The Good Times are back. Bonuses for everyone!
June 16, 2009 8:18 PM | Reply | Permalink
Immense private interests are amassed against the public interest
That is a perfect and complete description of what is standing in the way of much social progress in this country.
June 16, 2009 7:55 PM | Reply | Permalink
Barney Frank at House Banking can be relied on to try his best . . . .
A principal enabler of the subprime mortgage debacle?
Give me a break!
June 16, 2009 8:23 PM | Reply | Permalink
Let’s see if I’ve got this right.
1. Stop bankers from being bankers.
(By definition, banks arbitrage between short-term, highly liquid deposits and longer term less liquid loans. Can’t get much closer to “highly risky” than that.)
2. Stop any bank from enjoying scale economies.
and,
3. Shift the credit rating agencies paycheck from the left pocket of the financial sector to the right pocket; don’t let big institutional investors talk to the people responsible for executing their monthly payouts to pensioners and other routine transactions; and make sure the regional Fed presidents don’t know and have no understanding of their own districts.
.
Sounds like a recipe for disaster to me.
= = = = =
ct,
The United States Mint, originally part of the Department of State, prints money. 210 years ago, it became independent, and 136 years ago was reabsorbed by the Department of the Treasury. 28 years ago, it shifted to be directly under the Treasurer. The 42nd, and current Treasurer is Ms Anna Escobedo Cabral.
June 16, 2009 9:54 PM | Reply | Permalink
The Mint makes coins. They do not print dollars. (Maybe they should, but they do not.)
June 17, 2009 1:28 AM | Reply | Permalink
This all sounds nice, in theory. In practice, I don't see how it it accomplished:
1. How do you stop bankers from making excessively risky loans. More specifically, how do you stop them from creating "things" like CDO's and stranged securities? I call them "things" because no one is really sure what they are or how they will function. The common law is not really able to deal with these "things," so you lose an important tool for controlling them.
If you simply prohibit certain "things" the big money boys very creative (and crooked) minds will just dream up new ones. It would seem that you would have to have a list of permitted investments. Everything else is prohibited until such time as it can be approved by the regulators. One can already hear the screams about "big government" stifling innovation.
2. Being too big too fail is not the same as being too big to be reorganized. With TARP I and TARP II, we passed up a golden opportunity to reorganize these "too big" organizations. If anyone thinks that engaging in anti-trust litigation is going to be easy -- I would just remind everyone of the Microsoft case. It would have been so much easier to let the big boys fail, nationalize them, break them up, and sell them off in smaller pieces. If the powers to be had been serious about dealing with "too big to fail" organizations, they would have done so.
3. I don't see a mechanism for getting purchasers to actually pay for credit ratings. Think of them as a form of advertising.
Say you have a security you want to sell. Make it easy -- you are a local government trying to sell bonds to fund the purchase of a new jail. To make your bonds more attractive to potential investors, you have them rated. (Yes, it is possible to sell unrated securities.) So you pay a rating service to rate your bonds -- and supply the information you request -- and your attorneys, accountants and other directors all certify that the information they have provided is true and correct. The ratings agency then issues a rating based on these certifications.
But what if someone lies? Attorneys and accountants are less likely to do so, because they have licenses to lose. The problem with the securities which failed are that the people providing the information, mortgage brokers and the like, had every incentive to lie. So you have a bunch of securities which were rated based on a tissue of lies.
Thus, in addition to the fact that you will have a powerful industry fighting you tooth and nail every step of the way, there is also a fundamental difficulty in crafting effective solutions in the first place.
June 17, 2009 10:36 AM | Reply | Permalink
The whole problem comes down to the irresistible lure of truckloads of money. An easy fix is to make those truckloads shrink to toy wagon loads. We can do that quite easily with the income tax system. Tax obscene profits at equally obscene tax rates. Simple.
Now, what should we work on?
June 17, 2009 1:28 PM | Reply | Permalink