The essential function of the banking system is to take money from savers and other holders of capital and lend it to borrowers. Banks serve as intermediaries in this process, taking capital in the form of deposits and deploying it in the form of loans. Without the intermediation of banks, holders of capital would have a harder time obtaining returns and borrowers would have a harder time getting loans. Capital would flow less freely and economic growth would probably be slower. Banking--i.e., the original form of financial intermediation--worked because bankers provided the expertise needed to make sound, profitable loans. Because bankers held the loans, they managed them prudently to minimize loan losses.
A very important innovation in financial intermediation in the last 30 years was securitization of loans. This was a process in which banks bundled together loans into asset backed securities and sold interests in these securities to investors. Through the magic of financial engineering, stodgy residential mortgages, and eventually credit card, auto and commercial loans, often ended up in AAA-rated investments sold on Wall Street. Banks liked securitization because it provided fee income from making and selling loans, and then managing them, while supposedly transferring the risk of credit losses to the investors. Funds obtained from the sale of the loans would be used to make new loans, with more fee income generated. Loan losses would go down because fewer loans would be held. The banks' return on capital presumably could go up as banks became fee earning entities rather than lenders bearing the risk of credit losses. The real lenders, the investors in the securities, were often getting investments that were supposed to be about as safe as U.S. Treasuries.
We know how this story ended. The banks got so good at marketing their financial marvels that everyone and their uncle, including municipalities in Norway, wound up buying America's biggest export: loans. Banks' demand for loans, especially mortgage loans, became voracious and anyone with a pulse and signature could get one. Trillions of dollars were invested in mortgage backed securities and derivatives thereof like the now infamous CDOs. The securitization market became the dominant and unregulated sector of commercial banking. Risk wasn't managed because it supposedly was being dumped on--whoops, transferred to--the investors. Things would have worked out fine if the laws of economics had been suspended and the real estate market had kept rising forever.
But when fantasies collide with reality, it ain't reality that loses. Now, in the aftermath of the mortgage crisis and credit crunch, investors avoid securitizations like the plague, because securitization proved to be a plague on investment portfolios. CPR administered by legions of federal paramedics has raised a faint pulse in the securitization market, but the Fed can't forever continue its role as the buyer of first and last resort in the securitization market. Realistically speaking this patient won't recover. Trillion dollar markets are now billion dollar markets, and that's only for carefully screened bundles of loans to prime borrowers. Subprime loans, to the limited extent they are made at all, couldn't be sold for a nickel.
In spite of trillions of dollars of bailout money, cheap credit and other federal accommodations, the big banks aren't lending. Smaller banks are pulling back, and can be expected to scale lending down even more next year as commercial real estate losses take hold and unemployment rises. The credit crunch isn't over. It's simply shifted from money center banks to consumer and commercial borrowers. In other words, it's gone from Wall Street to Main Street.
New lending is badly needed. Securitization has lost credibility with investors and won't play a major role in the future. A new form of financial intermediation is needed. It shouldn't be complex or novel, because today's holders of capital, afflicted with battered investors syndrome, won't go near anything smacking of financial engineering. Reliability is far better than genius when your retirement money or college fund is at risk. Using familiar, existing structures would be the easiest way to go.
Back in the days when a single black and white TV in the living room and one car in the garage were considered hallmarks of a comfortable middle class life, banks were securitizations. They made a variety of loans, held them in their portfolios (effectively bundling them) and paid depositors interest from the interest paid by borrowers. In effect, the depositors had a de facto interest in the bank's portfolio of loans. Not all banks got AAA ratings, but federal deposit insurance was more than the equivalent so depositors considered their money safe.
A quick way to steer credit back toward Main Street would be to offer regulatory advantages to banks chartered (or rechartered) to lending primarily to Main Street--i.e., to consumers and businesses. For example, let's say we require a bank to lend at least a third of its deposits to consumers, another third to businesses, and a minimum of 90% to consumers and businesses combined (so that if the bank loaned 35% to businesses, it would have to lend at least 55% to consumers). Such a Main Street bank could be allowed to offer federally insured accounts up to $1 million or even $5 million per customer for interest bearing accounts (compared to current limits of $250,000); non-interest bearing accounts today are already insured without limit but that hasn't solved the Main Street credit problem. With heightened federal deposit insurance coverage, Main Street banks could attract larger depositors looking for safety, and the government would funnel more credit to those who today are crunched.
Many of America's smaller financial institutions could probably transform themselves into Main Street banks with relative ease, since they tend engage in traditional commercial banking. Credit unions, in particular, might find Main Street banking familiar. Since federal banking regulators are imposing greater prudence on all banks, raising the insurance deposit limits shouldn't result in a surge of reckless lending. Besides, the fact that there is no securitization market in which to dump dicey loans would make Main Street banks more cautious anyway. The cost to taxpayers of Main Street banking's higher deposit insurance coverage could be ameliorated by the fact that federal deposit insurance is paid for, in the first instance, by premiums charged to the banks. Taxpayers only provide backup. Main Street banks could be required to pay higher premiums for their better coverage.
Of course, it's likely the big money center banks would be vociferously unhappy about any such proposal, since they couldn't transform themselves into Main Street banks. They're too heavily invested in stock and commodities trading, investment banking and other activities that generate very large employee bonuses. But Wall Street's engineers are looking for lucrative ways to buy up whole life policies, not make loans to consumers or to the small businesses that typically do much of the hiring in an economic recovery. The big banks are not serving the public need for credit, and we need someone who will. Chartering Main Street banks may be a quick way to revive lending to the real economy.
Showing posts with label financial regulation for the future. Show all posts
Showing posts with label financial regulation for the future. Show all posts
Saturday, October 31, 2009
Sunday, June 21, 2009
Will the Financial Regulatory Reform Package Work?
Jen-Brad-Angie-Lindsey-Britney-Jon-Kate.
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.
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.
Monday, January 26, 2009
Financial Regulation for the Future
As the Obama Adminstration begins the process of reforming the financial regulatory system, the usual crew of columnists, commentators, pundits and bloggers are putting forth laundry lists of suggestions. Regulate credit default swaps, we are told. Formalize the derivatives markets, with centralized pricing processes like exchanges and centralized settlement and clearance functions. Tighten up capital requirements for financial institutions, and step back from the do-it-yourself risk-based capital requirements permitted under current international bank regulatory standards (which, in effect, allow financial institutions to largely decide for themselves how much capital to set aside; not surprisingly, they gave themselves higher grades for risk management than outsiders might have, with sad results that are all too familiar today). Establish prudent standards for mortgage loans, especially subprime loans, adjustable rate loans and any loan that may involve increases in monthly payments. Substantially increase the extent of governmental oversight of financial institutions, and make sure that hedge funds are covered. Make unequivocally clear what the heck Fannie Mae and Freddie Mac are and how much responsibility the federal government will have for their liabilities. Also make unequivocally clear what the major banks and their shareholders can expect from the government when a financial crisis hits. When Bear Stearns was too big to fail, but the much larger Lehman Brothers wasn't, it's no wonder that interbank lending evaporated last fall. Do something to definitively clean up bank balance sheets, like create a bad bank to buy toxic assets or nationalize troubled banks.
There is one point that may have been missed. It's important to regulate for the future. Like many generals, the regulators may be tempted to fight past wars. Almost all the suggestions for reform focus around past problems. These problems will be examined in depth as investigations are conducted. How things went wrong and how they could have been prevented will be analyzed in detail. Stringent regulations and controls will be instituted to prevent a repetition of the past. Enforcement actions, if warranted by the evidence, will be taken to emphasize the point.
But the past probably won't repeat itself. The securitization market for mortgages and consumer loans has largely evaporated, and you couldn't find a new CDO today if you wanted to. Credit default swaps aren't enticing with few creditworthy counterparties available and no centralized system of settlement and clearance. Liar loans and the like have left the scene as banks impose actual credit standards on borrowers because they can't sell loans to investors any more and therefore need to make responsible lending decisions. Almost all of the senior bank executives who wallowed in leverage are now pursuing other opportunities.
The most important task for financial regulators is to look for the battles that will be fought in the future. The financial services industry is second only to high tech in its capability for innovation. For perhaps the next five to ten years, banks and other financial institutions will be reasonably prudent, either because they will have learned their lessons or the government regulators peering over their shoulders will ensure that they learn their lessons. But, just as summer turns to fall and fall turns to winter, the financial services industry will seek to develop new products and services that will ease investor savings out of the scope of regulatory oversight and into another brave new unregulated world where profit margins are higher, executive bonuses are larger, and bureaucrats are scarcely to be seen. This is when the lunacy could begin anew. To guard against such a replay, regulators must not only change rules but also perspectives.
First, regulators should stay current with financial innovation. Congress put the regulatory agencies on the map to guard against the failings of markets. We know from the past 300 or more years that the financial markets cycle through booms and busts, and then more booms and busts. Another boom and bust is inevitable. How it will occur is presently unknown. But one can fairly predict that some time in the next few years, a 25-year old MBA or two will design a new financial thingamajiggy that will not be subject to government regulation and will catch on in the market. As soon as the higher ups in the big banks notice this development, their eyes will widen at the thought of grander bonuses and they will push this product to the edge of every imaginable envelope. Investor savings will be siphoned off into the great unregulated beyond and perhaps placed at far greater risk than investors realize. Bad things will happen, hair will be pulled, teeth will be gnashed, blame will be assigned and lives will be ruined. Regulators must be proactive in monitoring the development of financial products, and the ways in which they are used. Since the financial services industry is so highly innovative, regulators must make every effort to keep up with innovation; not after the fact but as it occurs. This can be done. It's simply a matter of gathering the information. The federal bank regulators and the SEC have examiners who can get up-to-the-minute information about bank activities. They and other regulatory staff should make it a priority to keep up with financial innovation and how new products are being used. Banks will grumble about giving potentially proprietary information to the government. But that's life. After the current debacle, that's a small price to pay for restoring investor confidence, and for the massive amounts of taxpayer dollars they have received and will receive.
Second, regulators should believe in themselves. In the past, attempts by a few regulators to assert authority over derivatives were met by, among other things, assertions that government bureaucrats couldn't understand such sophisticated products and would surely regulate them in a way that would hamper the markets. Some of these assertions even came from senior regulatory officials. Bureaucratic dumbness, if it exists, isn't an excuse to abandon governmental protection of investors, depositors and the financial system as a whole. Hire smarter government employees, if necessary. But the truth is that (a) the government has plenty of intelligent people who can understand complex financial products if they obtain enough information; and (b) very few people in the private sector truly understood these products, as is abundantly evidenced by the catastrophe that has resulted from their misuse. Government employees have sometimes achieved great things when they believed in themselves, worked hard, gave up evenings and weekends for the job, and refused to be held back by naysayers. Morale and zeal at the SEC have been lagging. While the stereotypical ultra-cautious, office-politicking, perks-obsessed, responsibility-avoiding, pension-awaiting bureaucrat is much too common way too often, there remains a cadre of committed public servants at the SEC who can, if given the opportunity, do the world a world of good. They have been crippled by a hostile White House, an unsupportive Congress, and the worst agency leadership in a generation or more. If they are given a chance to vindicate the public interest, they can and will. The financial regulators, including their leadership, must believe in themselves and in their capacity to do good. If they do, they will.
Third, to the Congress and the White House, start by healing thyself. The regulatory structure in the United States is meant to be independent of politics. Way too much for way too long, it has been anything but that. In the world of federal regulation, there is, separate from political considerations, such a thing as right and wrong, good and bad. Regulators must be allowed to call strikes when the pitch is inside the strike zone, regardless of who the batter may be. They must be allowed to quarantine those that could spread infectious disease, even if they are highly placed on Wall Street. One of the greatest impediments to regulatory proactiveness has been political pressure. Congress has a legitimate oversight function. But neither it nor the White House should protect the culpable, reckless or those that pose a risk to the financial system, and unfortunately one cannot say that the slate is clean in this respect. When the state police can write anyone, including the governor and the President, a speeding ticket, you'll have public safety on the highways. Things aren't different in the world of financial regulation.
There is one point that may have been missed. It's important to regulate for the future. Like many generals, the regulators may be tempted to fight past wars. Almost all the suggestions for reform focus around past problems. These problems will be examined in depth as investigations are conducted. How things went wrong and how they could have been prevented will be analyzed in detail. Stringent regulations and controls will be instituted to prevent a repetition of the past. Enforcement actions, if warranted by the evidence, will be taken to emphasize the point.
But the past probably won't repeat itself. The securitization market for mortgages and consumer loans has largely evaporated, and you couldn't find a new CDO today if you wanted to. Credit default swaps aren't enticing with few creditworthy counterparties available and no centralized system of settlement and clearance. Liar loans and the like have left the scene as banks impose actual credit standards on borrowers because they can't sell loans to investors any more and therefore need to make responsible lending decisions. Almost all of the senior bank executives who wallowed in leverage are now pursuing other opportunities.
The most important task for financial regulators is to look for the battles that will be fought in the future. The financial services industry is second only to high tech in its capability for innovation. For perhaps the next five to ten years, banks and other financial institutions will be reasonably prudent, either because they will have learned their lessons or the government regulators peering over their shoulders will ensure that they learn their lessons. But, just as summer turns to fall and fall turns to winter, the financial services industry will seek to develop new products and services that will ease investor savings out of the scope of regulatory oversight and into another brave new unregulated world where profit margins are higher, executive bonuses are larger, and bureaucrats are scarcely to be seen. This is when the lunacy could begin anew. To guard against such a replay, regulators must not only change rules but also perspectives.
First, regulators should stay current with financial innovation. Congress put the regulatory agencies on the map to guard against the failings of markets. We know from the past 300 or more years that the financial markets cycle through booms and busts, and then more booms and busts. Another boom and bust is inevitable. How it will occur is presently unknown. But one can fairly predict that some time in the next few years, a 25-year old MBA or two will design a new financial thingamajiggy that will not be subject to government regulation and will catch on in the market. As soon as the higher ups in the big banks notice this development, their eyes will widen at the thought of grander bonuses and they will push this product to the edge of every imaginable envelope. Investor savings will be siphoned off into the great unregulated beyond and perhaps placed at far greater risk than investors realize. Bad things will happen, hair will be pulled, teeth will be gnashed, blame will be assigned and lives will be ruined. Regulators must be proactive in monitoring the development of financial products, and the ways in which they are used. Since the financial services industry is so highly innovative, regulators must make every effort to keep up with innovation; not after the fact but as it occurs. This can be done. It's simply a matter of gathering the information. The federal bank regulators and the SEC have examiners who can get up-to-the-minute information about bank activities. They and other regulatory staff should make it a priority to keep up with financial innovation and how new products are being used. Banks will grumble about giving potentially proprietary information to the government. But that's life. After the current debacle, that's a small price to pay for restoring investor confidence, and for the massive amounts of taxpayer dollars they have received and will receive.
Second, regulators should believe in themselves. In the past, attempts by a few regulators to assert authority over derivatives were met by, among other things, assertions that government bureaucrats couldn't understand such sophisticated products and would surely regulate them in a way that would hamper the markets. Some of these assertions even came from senior regulatory officials. Bureaucratic dumbness, if it exists, isn't an excuse to abandon governmental protection of investors, depositors and the financial system as a whole. Hire smarter government employees, if necessary. But the truth is that (a) the government has plenty of intelligent people who can understand complex financial products if they obtain enough information; and (b) very few people in the private sector truly understood these products, as is abundantly evidenced by the catastrophe that has resulted from their misuse. Government employees have sometimes achieved great things when they believed in themselves, worked hard, gave up evenings and weekends for the job, and refused to be held back by naysayers. Morale and zeal at the SEC have been lagging. While the stereotypical ultra-cautious, office-politicking, perks-obsessed, responsibility-avoiding, pension-awaiting bureaucrat is much too common way too often, there remains a cadre of committed public servants at the SEC who can, if given the opportunity, do the world a world of good. They have been crippled by a hostile White House, an unsupportive Congress, and the worst agency leadership in a generation or more. If they are given a chance to vindicate the public interest, they can and will. The financial regulators, including their leadership, must believe in themselves and in their capacity to do good. If they do, they will.
Third, to the Congress and the White House, start by healing thyself. The regulatory structure in the United States is meant to be independent of politics. Way too much for way too long, it has been anything but that. In the world of federal regulation, there is, separate from political considerations, such a thing as right and wrong, good and bad. Regulators must be allowed to call strikes when the pitch is inside the strike zone, regardless of who the batter may be. They must be allowed to quarantine those that could spread infectious disease, even if they are highly placed on Wall Street. One of the greatest impediments to regulatory proactiveness has been political pressure. Congress has a legitimate oversight function. But neither it nor the White House should protect the culpable, reckless or those that pose a risk to the financial system, and unfortunately one cannot say that the slate is clean in this respect. When the state police can write anyone, including the governor and the President, a speeding ticket, you'll have public safety on the highways. Things aren't different in the world of financial regulation.
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