Financial Regulatory Overhaul

to be pared back? As fault lines emerge among private and public players? Two good articles today on the pace and direction of the regulatory reform of financial services and financial markets. I'm light-blogging the next couple of days, as I'm traveling to Palo Alto for a meeting of the Hoover Task Force on National Security and Law, and so mostly thinking about things like counterterrorism, direct part in hostilities, predators and targeted killing ... but these are articles are timely, well-reported, and useful to those of us keeping track of regulatory reform.

The first, by Zacharay Goldfarb in the Washington Post, Tuesday, June 9, 2009, gives an excellent overview of the "fault lines" developing over the direction of financial services overhaul. The result of the lobbying battles is

likely to shape how much profit banks will make, who can get a mortgage, which federal regulators oversee different corners of the economy -- and, ideally, whether the government is prepared for future financial threats.

With so much money and power on the line, interests inside the government and out are not waiting for the administration to reveal its plan, which sources say will be detailed next week. Lobbyists for financial firms and consumer activists, among others, have been meeting privately with the Treasury Department and the White House to press their views, according to people briefed on the discussions.

So who is on what side of what? What are the fault lines that are forming - fluid, as Goldfarb notes - but coalitions joining and shifting:

-- Financial firms, for instance, have closed ranks in vigorously opposing a proposal for how mortgage lending, credit cards and mutual funds will be regulated.

-- Big banks are squaring off against smaller ones over proposals for consolidating regulatory powers in a few agencies.

-- Banks and hedge funds find themselves on opposite sides in the debate over how to regulate the trading of derivatives, an exotic financial instrument that aggravated the financial crisis.

-- And government agencies, jealous of one another's existing powers and prestige, are also clashing over plans to redistribute their authority.

The article walks, offering very useful interviews, through each of these categories. The second article is from the Tuesday, June 9, 2009, Wall Street Journal, and the front page headlines is quite categorical: "Finance Reforms Pared Back." It offers the case that the "Obama administration is backing away from seeking a major reduction in the number of agencies overseeing financial markets ... [according to sources] the current alphabet -soup of regulators will remain mostly intact."

My feelings about this are very mixed, for all the usual reasons of trying to regulate a system that shares hugely important features as a system (as in, systemic risk) but also has many apples and oranges and kiwis and star fruit, too. The former argues for a single overarching regulator; the latter, for the alphabet-soup. That's all I can say now, but the articles are well worth reading.

A Law Dawg:
Star fruit? I fear it may be star chambers before this is over with.
6.9.2009 10:45am
"... derivatives, an exotic financial instrument that aggravated the financial crisis."

This line doesn't make a lot of sense. First of all, derivatives is plural - it's not just "an" exotic financial instrument. There are a bazillion (technical word) different derivatives, some of which may have aggravated the crisis, others may have ameliorated the crisis.

I see stuff like that and I wonder how much the writer really understands what he's writing about.
6.9.2009 10:53am
Kenneth Anderson:
Gab: true, although these articles are mostly about the politics and lobbying, something that political reporters are better equipped to deal with.
6.9.2009 10:55am
Jon Roland (mail) (www):
It should be clear that a conventional regulatory regime of issuing regulations enforced by an army of bureaucratic administrators with violations prosecuted as crimes would not have prevented the current debacle, and won't prevent the next one. Besides being unconstitutional, such regulation doesn't work, at least for things like financial markets, where the underlying problem is the emergence of large organizations or collective behaviors that evade accountability and defeat market mechanisms. We need a new approach, or rather, an old one that has fallen into disuse. The grand jury of randomly selected citizens, with a charter to investigate the internal workings of such organizations and behaviors, not so much with a view to enable prosecutions, as to discover and report dangerous practices that require correction by the stakeholders before disaster occurs.

This approach does not, of course, yield a patronage army that can be expected to vote for the party that created their jobs. That should be resisted.

We also need to atomize banking. Just as anyone can now be his own publisher, so we need to remove impediments to everyone becoming his own bank, with his computing device performing all the functions of a bank. The government wouldn't like that, of course, because having only a few banks, all under government control, gives it a power it thinks it needs, but that power, like most other kinds, is corrupting, and it would be better off without it.
6.9.2009 11:00am
rosetta's stones:

I think it's a valid usage. I was reading about the perils of mortgage backed derivatives years before this all happened, and I'd say this usage was directed at that in particular. The message then was that these derivatives posed an underlying hazard, only partially understood, and undefined as to potential triggering mechanisms and timing. I didn't understand it then, or give it much notice. I am now. So's my bank account.
6.9.2009 11:06am
Houston Lawyer:
This new emphasis on regulation will be worse than useless. All of the financial regulatory agencies are now running around vigorously enforcing petty rules to try to show how bad ass they now are. The SEC is really going all out to basically try to dictate how executives are paid. The level of disclosure asked for is not just invasive but of no practical use whatsoever to the investing public. FINRA, which took the place of the NASD regulating broker-dealers, is substantially worse. It appears to be staffed entirely with petty minded bureaucrats who get off on making life difficult merely because they can. Meanwhile, they are all fighting the last war instead of preparing for what may come in the future.
6.9.2009 11:12am
[insert here] delenda est:
Apologies for those who have already read it (everyone I expect) but this puts it so clearly:

QUICK: If you imagine where things will go with Fannie and Freddie, and you think about the regulators, where were the regulators for what was happening, and can something like this be prevented from happening again?

Mr. BUFFETT: Well, it's really an incredible case study in regulation because something called OFHEO was set up in 1992 by Congress, and the sole job of OFHEO was to watch over Fannie and Freddie, someone to watch over them.
And they were there to evaluate the soundness and the accounting and all of that. Two companies were all they had to regulate. OFHEO has over 200 employees now. They have a budget now that's $65 million a year, and all they have to do is look at two companies. I mean, you know, I look at more than two companies.

QUICK: Mm-hmm.

Mr. BUFFETT: And they sat there, made reports to the Congress, you can get them on the Internet, every year. And, in fact, they reported to Sarbanes and Oxley every year. And they went--wrote 100 page reports, and they said, `We've looked at these people and their standards are fine and their directors are fine and everything was fine.' And then all of a sudden you had two of the greatest accounting misstatements in history. You had all kinds of management malfeasance, and it all came out. And, of course, the classic thing was that after it all came out, OFHEO wrote a 350--340 page report examining what went wrong, and they blamed the management, they blamed the directors, they blamed the audit committee. They didn't have a word in there about themselves, and they're the ones that 200 people were going to work every day with just two companies to think about. It just shows the problems of regulation.
6.9.2009 11:27am
RichW (mail):
Delanda, John Roland &Houston Lawyer all make valid points but the reality is that Fannie and Freddie worked the way the congressional masters want them to. They in turn changed the rules so the lending banks stepped in line. The people in congress see mortgages and the like as a way of garnering votes and ensuring the long-term growth, (not survival, growth) of the loyal voter. It has been said elsewhere that by the time all the proposed changes are done more than 50% of the population will not pay taxes or will be given rebates of some sort. How many times where there you-tube videos of people saying he is going to pay my mortgage, buy my gas and so forth. A sense of entitlement without and sense of work is being inculcated into large numbers of people especially through schools and parental example. I teach at a good state university, but the number of students that come in feeling that they deserve an 'A' is amazing. They keep talking about being fair, not about earning anything.

My father grew up in NYC before the depression and through it. His grandfather and uncles walked to work because they could not afford to spend the 5 cents on the subway. They never talked about anything be fair or not fair, it just was and you worked for what you got. Did I have it easier then him or them, yes! Did I have to work hard, you bet. Am I a grouchy old guy saying you kids have it easy, maybe. But I do have many students that come to me when they get a C and say that I must have done something wrong because they were expecting an A. And then proceed to really argue about it.

Sadly, Congress is in the business of perpetuating their job and perks little else and I feel we are seeing the results and it is most likely going to get worse.
6.9.2009 12:23pm
Jon Roland (mail) (www):
RichW makes the key point that Congress and the regulators they unleash on us make political decisions instead of sound, market-informed, economic decisions, and the result is disasters. Congress is no more qualified to manage the economy than some executive czar, because they can't acquire or use all the information that constrains the behavior of markets, and because they make decisions using utility functions that result in economic disaster.

That having been said, there will be a demand from the public to do something to avoid future debacles, and there are things that can be done. But they aren't political things.
6.9.2009 1:06pm
Mark N. (www):
I suppose the problem is that the *markets* also seem to have been unable to acquire or use all the information that economic theory assumes they ought to have been able to do, in this case. Some of that was government distortion, sure, but I don't think all of it can be blamed on that: the scale of losses was much larger than the actual value of bad mortgages, and much more widely entwined throughout the financial sector.

Of course, these sorts of myopic pay-no-mind-to-risk bubbles followed by destabilizing crashes have been around about as long as finance has been around. There's pressure to do something about them because they can be quite destabilizing, and if the government doesn't do something about them, it's the sort of circumstance in which populists with pitchforks threaten to substitute their own solutions.

Perhaps because it doesn't deal in "real" products, finance seems more prone to these sorts of feedback loops and total disconnect from economic fundamentals than, say, the restaurant business. At the end of the day, the restaurant has to feed people food they want, and purchase it from suppliers who can provide it, so there's relatively frequent checks on whether the owner's idea of a restaurant and the reality are out of sync or not. Finance seems to be able to avoid this for longer stretches, since the "product" is trading of notional entities with paper relationships to other notional entities, only backed in theory by some (over-committed) real items through a long and muddy chain.

I mean, at one point finance was 15-20% of the US stock market by capitalization, and around 40% of corporate profits. Since the finance industry is essentially overhead---it exists to operate and facilitate the markets in which the real economy operates---that's quite bizarre, and indicates at the very least some sort of capture/distortion of the market by the ostensible market-operators.
6.9.2009 2:19pm
I still think that significant financial reforms pass. While history does not have a track record of appointing particular extreme judges during periods of single party control, many of the most of the biggest legislative reforms have come when a single party has controlled Congress by safe majorities and held the Presidency.

Financial system reform is very much the most obvious and while technical, best understood, of the possible responses to the financial crisis.

And, the Obama-Biden ticket understands the issues personally much better than any President in the past generation. Biden's reputation was as the Democrat most closely tied to the financial sector before he became Vice President. Obama openly mused about the risks of cognative capture he faced after spending so much time with investment bankers and finance types on the campaign trail, and routinely rubbed shoulders with Chicago school law and economics types in his professorial career. In the U.S. Senate, one of Obama's most notable bills sought to reform international asset protection and taxation. No President has ever assembled such a massive army of wonks before even taking office to assess detailed policy issues in transition teams. Obama's team knows where the bodies are buried when it comes to financial regulation.

Like most Democrats, Obama wants to be remembered as a domestic policy President, not a war President.

I would be shocked if we don't see significant financial system regulatory reform of some type, notwithstanding all the opposition that the various interests involved can muster.
6.9.2009 4:14pm
Cato The Elder (mail):
There is no prima facie reason that the financial industry shouldn't be a substantial percentage of our economy. Look at the close analogy of Apple. They outsource most of the actual manufacturing and building to offshore companies in Asia, yet they capture the major portion of the value-add from their product sales simply by envisioning new ways of putting cheap components into an aesthetic and remarkably functional form factor. I would say, as I type this comment from my Macbook Pro, that we as consumers are no worse for Apple's enviable profit margins. I am not using the proper language or rigor to properly characterize this notion, but in the future most of the work that people perform will be the creating of abstract "blueprints" rather than actually fitting the pieces together.
6.9.2009 4:33pm
rosetta's stones:

"Biden's reputation was as the Democrat most closely tied to the financial sector before he became Vice President."

You're saying that as if you consider it to be a good thing. Yes, Biden is extremely tight with the crooks who brought all this turmoil on, much like Frank and Dodd. They, their friends and their families all do well, based upon those connections, and I expect the entrenched financial interests to continue to cash in on their past investment in all these people.
6.9.2009 4:39pm
KWC (mail):
And why are comments disabled on Bernstein's Israel post? I find that utterly inexcusable. For whatever reason, from time to time, contributors to this blog decide that they don't want comments on their posts. I'll suggest that there is no good reason for doing that.

It could be that the poster is worried about their post's inciting negative reactions. But what principled reason exists for distinguishing between when it is okay to speak at us (the commenters) and when it is okay for this blog to be a dialogue? If you can't defend your position, or if your statements are outlandish, that reflects a problem with your post, not us. Why are we punished?

It could also be that the poster expects there to be some "trolling" or "spam" that is offensive. But there is a mechanism for that. You can delete the comments, or better yet, ignore them. Why should legitimate speech be stifled just because certain people will abuse the forum. They always do anyway.

It seems to me that there is no obligation to allow comments on a blog. But once you do allow comments on a blog, you've opened the forum. And the forum should always be open. Picking and choosing which posts welcome comments and which do not cannot be justified by any legitimate rule. It is extremely condesceding. It sends the message that we should sit anxiously awaiting your wise words and, on occasion and only when you deem it appropriate, you, too, may speak.

In sum, David, we are not students in your classroom. Stop treating us that way.
6.9.2009 4:42pm

And why are comments disabled on Bernstein's Israel post? I find that utterly inexcusable. ....

I think you just demonstrated exactly why he disabled comments.
6.9.2009 9:22pm
Ricardo (mail):
I mean, at one point finance was 15-20% of the US stock market by capitalization, and around 40% of corporate profits. Since the finance industry is essentially overhead---it exists to operate and facilitate the markets in which the real economy operates---that's quite bizarre, and indicates at the very least some sort of capture/distortion of the market by the ostensible market-operators.

A lot of that increase in market cap share and corporate profits can be attributed to the trading desks of the big investment banks (and the investment banking arms of "universal banks" like Citigroup). They took massive, leveraged positions on the idea that certain assets, like those AAA-rated senior tranches of MBSs and CDOs, were mispriced. They made lots of money on these trades during the period of market craziness and then lost it all when the market corrected.

I don't think it represents any nefarious restraint of trade. Investment banks have seen brokerage commissions forced down so far by competition from discount, online brokerages that these make up a negligible amount of their total profits. Mergers and acquisitions was a good, profitable chunk of the business but much too cyclical to be relied upon. It was trading on own account that really made up the difference.
6.10.2009 12:56am
Mark N. (www):
Trading on own account being able to account for such a large share of the total economy still seems odd to me. If the economy and markets are functioning even approximately well, then most assets should be approximately correctly priced; basically all of free-market economic theory relies on this assumption that market mechanisms mostly work most of the time, with prices being set relatively well, and the "invisible hand" allocating capital and labor efficiently. There are of course always arbitrage opportunities, because no theory holds that every asset is always exactly properly priced; but if arbitrage profits are a large proportion of total economic activity, it seems to indicate something gone wrong.
6.10.2009 2:39pm

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