Will the Financial Regulatory Reform Package Work?

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Okay, now that we've taken care of the important stuff, let's turn to something boring. To evaluate the likely effectiveness of the new financial regulatory reform package, we should consider how the next financial markets boom, bust and morass will happen. The story begins with money (where everything on Wall Street begins).

High profit products sold by Wall Street tend to be those that are new, innovative and preferably (from the Street's point of view) complex. The newer and more unfamiliar the product, the less customers understand it and the larger the markup that can be charged. A new product is easily pitched as a better mousetrap--customers don't understand it well enough to know better. New products are readily used to create new fashions, and anything that's fashionable will be profitable.

Another key factor in profitability is regulation--or, rather, the avoidance of it. The less the regulators hover around, the more earnings reach the bottom line. It costs money to protect investors and consumers. Unregulated or lightly regulated financial products boost executive bonuses.

These are the most important reasons why we wound up having such big problems with CDOs, credit default swaps and all the rest of the derivatives market menagerie we now know and love so well. They were new, complex, not well understood and hardly touched by regulation. Wall Street took advantage of them to create a multi-trillion dollar unregulated banking industry, using SIVs and other holding tanks that the accounting rules allowed to be swept under the rug whenever anyone might be looking. The result was a vast, highly leveraged, unregulated, and virtually invisible banking industry that took so much risk it wrecked the economy and truck bombed the federal deficit.

The new financial regulatory reform package includes myriad provisions for dealing with derivatives, unpayable mortgage loans to the uncreditworthy, inadequate capital requirements for banks, oversight of firms whose viability can threaten the stability of the financial system, and various other issues that emerged during the past 18 months of financial crisis. The question remains, however, whether the government is building a mighty Maginot Line that clever financial engineers will outflank.

The next thing that is likely to blow up Wall Street won't be a financial product that now exists, since current products are or will soon be heavily regulated. The next thing will be developed when the contours of financial regulatory reform become clearer, and the product can be designed to steer around regulated territory. Since it doesn't exist yet, the new product has no name. For now, let's call it a chicken salad sandwich.

The chicken salad sandwich will be carefully crafted so that it doesn't fall within the legal definition of a security (to avoid SEC regulation), a commodities futures contract (to avoid CFTC regulation), a depository account (to avoid banking regulation), an insurance product (to avoid state regulation), or anything else that is heavily regulated. To the extent that it might slip into the crosshairs of a regulator, the financial firms and their legions of lobbyists will work every angle and fundraiser in Washington to ensure that it stays out of official purview. That's what happened with derivatives contracts in the 1980s and 1990s (and we're now paying the price). The financial services industry will try to repeat that "success" with the chicken salad sandwich. It will also work over the accounting standards setters to keep the chicken salad sandwich off any financial statements that anyone might have to disclose publicly. Information is power, and keeping information out of the hands of regulators and investors increases Wall Street's power (and profits).

Assuming the Street is successful in carving out an unregulated enclave for the chicken salad sandwich, it will drive truckloads upon truckloads of investor money into the promised land (or the land of promises, to be precise) and invest it all in chicken salad sandwiches. The price of chicken salad will rise, and then skyrocket. Fortunes will be made on Wall Street. Real estate values in the Hamptons and on the Vineyard will revive. Expensive, tasteless parties will again be reported in the society pages. Manufacturers of $6,000 umbrella stands will start hiring. Financiers will prosper, indulge and gloat. That is, until market forces we now know too well reach the point of excess and force the Street, once more, to say goodbye to all that.

The 88-page description of the proposed regulatory reforms issued last week includes a lot of talk about federal regulators working harder, better, more comprehensively and in greater coordination with each other. A lot of attention is paid to asset-backed securities, derivatives, hedge funds and other players in the recent financial drama. But there isn't much recognition of the likely source of future problems--innovative products designed to slip through the regulatory net. Yes, the proposal calls for the formation of a Financial Services Oversight Council that will, among other things, "identify gaps in regulation and prepare an annual report to Congress on market developments and potential emerging risks." That's nice: another government report.

But what we need is a strong mandate for lots of official curiosity about potential future economic time bombs. If everything done by all financial firms falls under future regulation (a possibility the current proposals do not seem to envision), the chicken salad sandwich could be produced by nonfinancial firms. That isn't hypothetical. Recall how Enron was a major player in the energy markets. You don't have to be a financial firm to speculate. The proposed regulatory reforms will require increased government funding, more civil servants and greater regulatory vigor. But it will be mostly wasted if chicken salad sandwiches are allowed to bloviate into another large, unregulated financial sector. The Panic of 1907, the stock market crash of 1929 and the recent debacle all involved significant leverage in largely unregulated financial markets which eventually collapsed and caused enormous collateral damage. By contrast, the 2000 tech stock collapse didn't bring down a large part of the financial sector and the economy continued to do reasonably well.

Curiously, the proposed reforms did not include a simple measure that might significantly reduce the potential for a future chicken salad debacle. The 1987 stock market crash, during which the Dow Jones Industrial Average dropped 22% in a single day, did not result in anything like the recession we are now experiencing. That, in all likelihood, is because the commercial banking sector, which in those days was separated from investment banking by virtue of the Glass-Steagall Act, was not seriously damaged by the stock market panic. Indeed, the Federal Reserve used commercial banks to prop up investment banks with a gush of credit. On the other hand, when Bear Stearns and Lehman teetered at the brink in 2008, there was no stable commercial banking sector for the Fed to use in similar fashion, and things got ugly.

Like the 2000 tech stock collapse, the 1987 stock market crash indicates that asset bubbles are less of a systemic threat when there exists a commercial banking sector that isn't heavily exposed to them. Congress, the administration, regulators and regulatees will be debating financial regulatory reform for many months to come. It is seriously heretical in today's Washington-New York orbit to suggest a revival of Glass-Steagall. But we don't need to call it Glass-Steagall. Let's call it a dill pickle. A dill pickle that insulates the commercial banking sector from the volatility of more speculative activities creates an anchor to the financial system and therefore the economy. Supported by federal deposit insurance, the dill pickle version of commercial banking would be boring, and not enormously profitable. But it would provide comparative stability. By contrast, the combined commercial-investment banks we have today create enormous risk and then spread it widely throughout the economy. When the risks are realized, pain isn't focused narrowly but instead spreads widely throughout the economy.

Moderation of risk encourages economic activity. That's why the corporate form of doing business, with limited liability to shareholders, was a crucial building block of the modern industrialized economy. Moderation of the risk of systemic financial failure is also critically important to economic health. That's why federal deposit insurance was enacted. But banks have become so large that the federal budget (or, rather, deficit) has become the financial system's true backstop. Breaking up the big banks into comparatively stable commercial banks and risk taking investment banks would reduce the size of some too-big-to-fail firms and lessen the economy-wide impact of financial volatility. There's no reason for people in Flint or Montgomery to bear the risks of financial speculation by Wall Streeters. They presently do so because the federal financial regulatory system allows that to happen. Things don't have to be that way.