The Geithner-Summers Proposal: Today's Foundation, Tomorrow's Crisis

Writing in the Washington Post this morning, Tim Geithner and Larry Summers outline a five-point plan for dealing with the underlying problems in our financial system, entitled A New Financial Foundation.

The authors are not completely clear on what they think caused the current crisis, but you can back out some points from their reasoning – and the implicit view seems quite at odds with reality.

1. Their view: Regulation is overly focused on safety and soundness of individual banks. Reality: There was a complete failure of safety and soundness supervision. This must be fundamental to any financial system – without this, you’ll get mush every time.
2. Their view: “A few large institutions can put the entire system at risk,” so we need a system regulator. Reality: you need to control the behavior of large institutions, more than a few of which got us into this mess. If you can’t come up with a proposal to prevent them from taking system-damaging risk (and there is nothing in today’s article about this), then break them up. The article mentions penalties for being large - higher capital and liquidity requirements for larger banks; we’ll see the details in/after Geithner’s speech tomorrow, but I am not holding my breath for anything meaningful.
3. Their view: All large firms will be subject to consolidated supervision by the Federal Reserve and there will be a council of supervisors. Reality: we have plenty of layers, up to “tertiary” regulators (and beyond, in some senses) and there is already enough opportunity for regulatory arbitrage. What prevents the biggest banks from capturing or manipulating regulators? There is no mention in today’s document of the extent to which everyone, including the authors, believed in the big banks’ risk management abilities last time – and continue to rely on the advice of their people today.
4. Their view: The originator “of a securitization” will be required to “retain a financial interest in its performance.” Reality: It was a big unpleasant shock when everyone realized that Lehman, Bear Stearns, and others had retained a large exposure to dubious financial products, some of which they had issued. We are back to the Greenspan fallacy here – if financial firms have an incentive not to screw up on a massive scale, they won’t.
5. Their view: “[T]he administration will offer a stronger framework for consumer and investor protection across the board.” This sounds incredibly vague and may be the worst news today. It looks like they are backing away from the idea of a Financial Products Safety Commission, for example as proposed by Elizabeth Warren.

And of course the complete omissions from this document are breathtaking. No mention of executive compensation or the structure of compensation within the financial sector. Not even a hint that the complete breakdown of corporate governance at major banks contributed to excessive risk taking. And no notion of regulatory capture-by-crazy-ideas of any kind.

There are a couple of positive notes towards the end. The administration will seek a resolution authority for dealing with failed banks, but we knew this already. And the authors recognize the need to change how financial systems operate around the world; unfortunately, there is zero detail on this crucial point.

Overall, there are no surprises here. Brick by brick, we are building the foundation for the next financial crisis; by all indications, it will be more disruptive and a great deal more damaging than the crisis of 2008-09. But presumably by then the authors will be out of office.

Comments

[Harry Tuttle]

Summers and Geithner are part of the financial establishment that got us where we are. Thus, any expectation of fundamental reform from within is naive at best.

2009 Jun 15 10:49 AM

[commoinsense1211]

ugggggg

2009 Jun 15 11:03 AM

[Larry House]

Did anyone really believe their ideas would be good for the markets? When has government action been helpful? Wait until we hear all the details on new taxes, etc. Reality is a bummer.

2009 Jun 15 12:15 PM

[austrian63]

I have not read their article only your summary but from your summary, the absolute ignorance as well as denial implicit in their belief system is scary. First of all, the idea that the fed will regulate sytemic risk is laughable when the Fed is the proximate cause of all systemic risk. Any one see the fox guarding the hen house here? The fed keeps interest rates artificially low and expands bank reserves so as to make bank credit artificially cheap and plentiful within the economy. Unprofitable projects look profitable when debt is cheap and plentiful. Debt always adds risk. How will the Fed make sure risky behaviour is "controlled" when they keep adding more risk to the mix?

All I can say is fasten your selt belts with these guys in charge. We now have arsonists in charge of putting out fires and improving future fire prevention. The inmates are indeed running the asylum.

2009 Jun 15 12:49 PM

[ElTiante]

Essentially, the Obama administration is taking regulatory power away from the Executive and Legislative branches of our government and transferring it to the (in reality) private-sector Federal Reserve. Less transparency, less accountability to the citizenry, less "regulation." Only a true rock star could sell this to the Dem Party base (just as Clinton sold NAFTA to them). Wall Street is getting their money's worth out of this administration.

2009 Jun 15 01:17 PM

[Mayer Amschel Rothschild]

I'm sorry, but I think that this summary is way too brief to learn anything from. And #4 doesn't actually sound like a terrible idea, because although the market corrects itself to eliminate bad new investment, creating an entirely new kind of easily-traded security can drive huge, huge amounts of money into it rapidly, before we really know what its risks are. I don't know that forcing the issuer to hold some of the risk of the security is the best answer, but it doesn't seem like a bad spot in the system to monitor.

2009 Jun 15 01:20 PM

[Doc 224899]

Any government recovery plan based on stealing money from people who earned it and spending that money on the creation of greater complexity and greater regulation and greater oversight by non-experts in government is doomed to failure.

Speaking of that, where the heck is the next broad market down-leg? We're at the end of a bear rally that resulted in a very, very overbought market. The news is all bad. The federal government is being run by a bunch of people who have convincingly reavealed themselves to be neo-marxist socialist ideologues, playing nice-nice with Islamofascists all over the middle east. Such politicians have never the friends of Wall Street, and certainly haven't demonstrated any love of corporate CEOs or the few remaining US manufuacturing firms or private investors or investment firms or banks. Our government now intends to destroy healthcare, having sent "The First Trial Attorney" to bully the AMA's leadership like GM's leadership and BOA's leadership were bullied previously (lawyerly types love their precendents), so we probably won't even be able to buy decent antidepressants by the end of the summer without a favorable grunt from Barny Frank. What the heck is holding up the DOW? Helium balloons?

2009 Jun 15 01:40 PM

[Apple Diner]

Thank god this nightmare only lasts four years...

2009 Jun 15 02:14 PM

[robert.b.ferguson]

This is all in line with the administrations stated goals. No surprises. Public sector health care "Competing." with private insurers of which there are about four hundred already competing will put an end to private health insurance very quickly. Team Obama wants to strip $300B away from Medicare/Medicade doctor/hospital compensation. This will lead to fewer practitioners accepting those program's patients and thereby broadening the so called crises giving the administration more ammunition. Unless we wake up single payer government health care and government supervision of all businesses will be here soon. Bring back Glass/Steagul and the uptick rule to help with the financial proplems. Introduce real tort reform to bring down medical costs.

2009 Jun 15 03:27 PM

[Big Bubbette]

Re-inact the Glass-Steagall Act. Pass HR 1207 and audit the Federal Reserve. Disband the Federal Reserve and bring the Treasury back under the control of the Congress. End mark-to-market and run a real stress test on the banks. Do not allow the banks to pass trillions of worthless toxic assets to the backs of the taxpayers.

That is all.

2009 Jun 15 04:34 PM

[Miolnir]

Regarding the last paragraph of the article:

"Overall, there are no surprises here. Brick by brick, we are building the foundation for the next financial crisis; by all indications, it will be more disruptive and a great deal more damaging than the crisis of 2008-09. But presumably by then the authors will be out of office."

Please help a newcomer to this website understand and learn-
"Who, what, where, when and how? will the next financial crisis occur due to this Administrations actions?"

That is quite a statement to make, in such a small paragraph at the end of the article and then just finish. I trust absolutely nothing coming out of Washington, so I am not arguing the point.

I would just like to read a whole new article about that last paragraph so I can try to keep my family and I treading what little water we have left.

Thank you for all the insights and knowledge gained here!

2009 Jun 15 06:44 PM

[Tom Armistead]

The proposal is sufficient in that it changes two out of three of the things that were "different this time" and made the debacle more severe than past crises. It partiallly mitigates the 3rd.

1) the investment banks, to include the now defunct Bear Stearns and Merrill Lynch, were supervised as Consolidated Supervised Entities (CSEs) by the SEC, which had been rendered spineless by weak leadership and laissez faire ideology. Moving the supervision to the Federal Reserve which knows banking and is not toothless will solve that problem.
2) Credit Default Swaps were not a factor in prior meltdowns, and in addition to being powerful and complex they were specifically exempted from any regulation. Per the proposal "all" derivatives will be regulated to prevent abuse and manipulation.
3) Excessive liquidity flooding the system in the wake of 9/11 created low interest rates and returns, leading to the abuse of leverage in an effort to overcome low rates. All that liquidity had to go somewhere. This is not a regulatory issue, but one of fiscal or monetary policy. However, higher capital requirments and better prudential supervision should reduce the danger of excessive leverage to manageable levels.

The plan or proposal is workable and adequate. Getting to proper legislation through Congress will be difficult. However, most of these people are aware that their dereliction of duty in passing CFMA, together with an ideology of deregulation that extended through the Clinton and Bush adminsistrations, are the proximate causes of the meltdown and they will perform adequately if subjected to enough pressure constituents back home who are out of work and facing foreclosure, 401ks decimated, etc.

2009 Jun 15 06:58 PM

[Moon Kil Woong]

The Fed is not a federal agency, it should not emulate or decieve the public it is one unless it's willing to me monitored and regulated as one. If it wants it's independence to grow its balance sheet without Congressional mandates and mismanage interest rate policy without executive and/or legislative guidance it better think twice.

I think Bernake, Summers and Geithener don't know why the Fed is suppose to be seperate from the government. It's because they are suppose to be able to do the politically distateful job of insuring our currency's value by raising interest rates to staunch inflation and to prevent run away economic bubbles that can lead to economic collapse and destabilization. As far as I am concerned they have done a very poor job so far.

If anything, they need to be further removed from Washington not closer to it.

The second point is that numerous agancies could have reigned in the banks, brokerages, and out of control derivatives growth. The fact is none of them did. If many agencies all bent under the sway of lobbyists what makes you think a single agency will be more immune to it. In fact, the Fed is basically a banker's lobby with extraordinary powers already. To ask it to manage it's own members is a far strech of the imagination. If you ascribe to this you probably also ascribe to letting the gangs manage our prisons and Congress dertermine whether its own members are ethical or not. Such a model fails in every case.

2009 Jun 15 10:09 PM

[mac123449]

As much as the Wizard Of OZ prints money and trys to stimulate the economy the fact is it won't work. The world needs a rest from all the years of crazy credit and expansion tax cheatin Geithner just let the economy fix itself and let it ride it needs a long sleep after partying all those years.

2009 Jun 15 10:25 PM

[Living4Dividends]

Milton Friedman put it best:
"The government solution to a problem is usually as bad as the problem."

2009 Jun 16 11:33 AM

[James Quinn]

You can't borrow yourself out of debt.

theburningplatform.com...

2009 Jun 16 01:50 PM

[metastar]

Stop complaining and get involved. Write, call fax and e-mail your local representative. Ask them to support the “Federal Reserve Transparency Act of 2009” (H.R. 1207). Audit the Fed. We need more transparency, not less.

2009 Jun 16 02:10 PM

[metastar]

www.opencongress.org/b...

2009 Jun 16 02:19 PM

[Tony L.]

The Ultimate Banking Solution

The only way these financial institutions ala J.P. Morgan, Goldman Sachs and the like got to become so big was because of a certain central bank created in 1913, President Wilson, by signing the act had sold the country off to a bunch of bankers, that effectively gave cartelizing power to these New York banks and thereby taking control of the U.S. banking system. The result has been robbery on a grand scale for the last hundred years in America.

The solution would be to rid of this pernicious central bank otherwise known as The Federal Reserve and let all banks stand on their own. Without big mummy to cry to the big banks could not collude with each other and dare engage in the biggest Ponzi scheme in the history of mankind by pyramiding money or what is officially called fractional reserve banking.

Fiat currency without hard money backing would then prove untenable and a gold standard would have to be reinstated.

2009 Jun 18 03:27 AM