Up Next: Financial Reform

Health care is a done deal and the immediate economic crisis has past (with years of recovery to come).  Next up for Obama and Congress is financial reform, which can be summed up as "how do we keep this from happening again."

The Plan
First, a look at the Obama administration's recommended financial regulation plan:

1. Giving regulators more monitoring authority (like the Consumer Product Safety Commission for toys).  "If your mortgage is a choking hazard, the government will issue a warning or a recall."
2. Financial firms must reduce their debt and hold more capital in reserve.  "If things go bad, there will be more money around to plug holes on the leaking ship."
3. Government can seize collapsing firms.  "If it's a total SNAFU, we'll just take them over."

Obama has also endorsed two other ideas.  First is the so-called Volcker Rule, which would prohibit banks from trading for their own profit, as opposed to on behalf of their clients.  Second is a bank tax, which would help recover the cost of the last bailout and help prepare for the next.

The Problems
However, there's a fair amount of criticism (same article) that these new rules will fall short.  On #2, the administration (and Senate) is being fairly loose about actual numbers.  So it's not clear if debt-to-capital ratios will be clear enough, e.g. "do I have to have a 20% down payment or a 1% down payment?"

And #3 is also problematic if left to regulators, since the folks in charge of the financial system for this crisis clearly used too little of their authority.

The Volcker Rule has also drawn a lot of flak for being insufficient or misdirected (check out the great chart explanation).

The weakness and vagueness of the Obama plan is the heart of Paul Krugman's criticism (did I mention he's a Nobel-winning economist?):

The Dodd [Senate] bill is similar to my concern that it’s too Hellenistic and not sufficiently Roman: it sets up a system that will work fine if we have first-rate regulators, but doesn’t seem robust to the mediocrity that is all too likely to prevail, sooner or later. [emphasis mine]

Without good regulation, what will happen is what just happened.  In good times (the 90s), investment banks make obscene profits.  In bad times, investment banks get bailed out by the government.  This concept is called lemon socialism, and it basically means that you privatize profits and socialize risk.

The History
Before we get to the proposed fixes, the history is really relevant.  Before the Great Depression, the banking sector had a panic every decade.  Banks speculated with deposits, and people lost everything.  Boo.

The Roosevelt administration responded to the Depression forcefully, and its new regulations (the Glass-Steagall Act) created a fairly inflexible system of rules to keep banks boring.

1. All deposits were insured (FDIC).  Bank runs stopped.
2. Banks must be boring - no more speculating with deposits or underwriting securities. 

The rules worked and the financial sector was stable for 50 years.  But in the 1980s, the rules left banks with a competition problem.  Banks (with savings deposits) had competition from mutual funds.  And businesses started borrowing money in the bond market instead of from banks. 

Since banks couldn't expand their business portfolio to compete (until the 1999 repeal of Glass-Steagall), "shadow banks" (Goldman Sachs, Lehman Brothers, etc) rose up to fill the void.  They had none of the rules about reserve capital or speculation that regular banks did, so they made fabulous profits on borrowed money throughout the 1990s and early 2000s.  And then the financial crisis hit and they went broke.  Ooops! 

Because government regulations hadn't kept pace, the government was forced to bail out these financial buccaneers to keep the entire credit market from collapsing (this actually is a big deal, since many companies make payroll by borrowing for very short terms, like overnight).  When the shadow banks fell, nobody wanted to lend, and this was locking up the economy.

So, will the Obama Plan fix everything?  Probably not.

Fixing the Obama Plan 
Krugman describes the fix pretty well:

"So what the legislation needs are explicit rules, rules that would force action even by regulators who don’t especially want to do their jobs. There should, for example, be a preset maximum level of allowable leverage — the financial reform that has already passed the House sets this at 15 to 1, and the Senate should follow suit. There should be hard rules determining when regulators have to seize a troubled financial firm. There should be no-exception rules requiring that complex financial derivatives be traded transparently. "

Canada, for example, has a very large banking sector but with very strict limits (a debt-to-capital ratio of 20:1, whereas the shadow banks in the U.S. were at 30:1 on the eve of the financial crisis).  And Canadian banks have weathered the downturn much better than their American counterparts.


The flexible parts of the Obama plan don't have to be discarded.  As pointed out in the first article on the Obama plan, discretion can be important.  An illustration is the "Schumer box," a requirement for all credit cards offers requiring the company to display the interest rate and annual fee prominently.  Card companies quickly learned to hide their fees in a variety of ways that did not require disclosure in the Schumer box.  Regulators must have the authority to be similarly nimble.

The Politics

Ultimately, financial regulation is a political issue and the position of the major players if fairly predictable:

Well, how about John Boehner, the House minority leader? Recently Mr. Boehner gave a talk to bankers in which he encouraged them to balk efforts by Congress to impose stricter regulation. “Don’t let those little punk staffers take advantage of you, and stand up for yourselves,” he urged — where by “taking advantage” he meant imposing some conditions on the industry in return for government backing.

Barney Frank, the chairman of the House Financial Services Committee, promptly had “Little Punk Staffer” buttons made up and distributed to Congressional aides. 

These punk staffers may be the only thing standing between the taxpayer and another boondoggle of a bailout.  Time to get a button.