Obama's Financial Reform - A Distraction from the Real Issues

By Simon Johnson

President Obama’s speech yesterday was disappointing. As a diagnosis of the problems that let us into financial crisis, it was his clearest and best effort so far. He didn’t say it was a rare accident for which no one is to blame; rather he placed the blame squarely on the structure, incentives, and actions of Wall Street.

But then he said: our regulatory reforms will fix that. This is hard to believe. And even the President seems to have his doubts, because he added a plea that – in the meantime – the financial sector should behave better.

The audience was comprised of our financial elite, but the Wall Street Journal reports “not one CEO from a top U.S. bank was in attendance” (p.A4). How’s that for demonstrating respect, gratitude, and a willingness to behave better?

Louis Brandeis, of course, would have seen things differently. The author of “Other People’s Money: And How The Bankers Use It,” was under no illusions concerning the underlying financial power structures and how they operated. He would have regarded an appeal to the better nature of bankers as somewhere between humorous and sad.

The only thing that will make a difference is regulation. This is the lesson of the 1930s in the US – the regulations imposed at that time created a financial sector that did not impede growth after World War II; basic intermediation (connecting savers and borrowers) worked fine and destabilizing frenzies were avoided. During this period, the financial sector came up with venture capital, ATMs, and credit cards – arguably the three most important financial innovations of the past 100 years, and much more helpful of real innovation than anything you’ve seen since 1980.

President Obama claimed that three regulatory proposals will make the system safer.

“First, we’re proposing new rules to protect consumers and a new Consumer Financial Protection Agency to enforce those rules.” This is a very good thing, and of course the banks are adamantly opposed. But this Agency will not by itself bring us financial stability; that requires change at the level of how banks and other financial institutions are operated.

Second, he talked about “gaps in regulation”; this is international finance bureaucrat code for mush (doesn’t the President know this?). The specific potentially interesting pieces he put under this heading were run together in this paragraph,

While holding the Federal Reserve fully accountable for regulation of the largest, most interconnected firms, we’ll create an oversight council to bring together regulators from across markets to share information, to identify gaps in regulation, and to tackle issues that don’t fit neatly into an organizational chart. We’ll also require these financial firms to meet stronger capital and liquidity requirements and observe greater constraints on their risky behavior. That’s one of the lessons of the past year. The only way to avoid a crisis of this magnitude is to ensure that large firms can’t take risks that threaten our entire financial system, and to make sure they have the resources to weather even the worst of economic storms.

Making the Fed responsible for the largest firms could work, but only if the Fed throws out pretty much everything about the Greenspan doctrine of cleaning up after financial messes, rather than preventing them. There is no indication they are moving in this direction.

The oversight council is unlikely to make a difference. If you ask someone, “Who is responsible for this problem?” and they answer, “Well, we have a committee,” does that make you feel better or worse?

The administration will not tell anyone the exact capital and liquidity requirements they are proposing, but close observers of the internal administration process have taken to calling the likely increases “dinky”. Remember, the last time our financial system showed this taste for risk and a comparable level of incompetence (prior to 1935), it had equity relative to assets roughly three times current levels (e.g., put into tier one-equivalent terms). There is no proposal on the table, either in the US or within the G20, that is even remotely in the right ballpark. President Obama has put his finger on the problem but is apparently unwilling to do anything about it.

The most remarkable phrasing is probably,

Even as we’ve proposed safeguards to make the failure of large and interconnected firms less likely, we’ve also proposed creating what’s called “resolution authority” in the event that such a failure happens and poses a threat to the stability of the financial system. This is intended to put an end to the idea that some firms are “too big to fail.”

It is very hard to understand how the administration can say this with a straight face. Certainly a resolution authority would help, but all bank interventions are negotiated receiverships or conservatorships of some kind. When banks are failing, they need a lot of money fast and you have them over a barrel. But if they are vast, complex, and – remember this – cross-border, then taking them over or shutting them down can be scary, whether or not you have a “legal authority”. Please point out to me (a) what the US is pushing the G20 to implement in terms of a cross-border resolution authority, and (b) how you would intervene in a bank like Citi (C) without a cross-border authority. This rhetoric around this issue is completely not serious – in fact, it’s a distraction from the real issues.

And, of course, the real issues were not mentioned at all.

1) The largest financial institutions have to be made smaller — aim to make them under $100bn in assets, roughly the size of CIT Group (CIT) which even this Treasury was willing to leave to its own devices. We can do it with legislation now or by regulatory fiat next time the behemoths get into trouble, but we should do it before they ruin us.

2) The people who run banks like to talk about “skin in the game” in various contexts, but they generally have only a small proportion of their wealth at risk in these financial institutions. This is not a panacea of course, but it is completely fair to ask them to stake a large part of their fortunes. If they respond that this is not fair because all kinds of things can happen that are beyond their control, you should say, “Agreed – so split your bank up and manage something much smaller.”

3) The revolving door between Wall Street and Washington is out of control. There is no way people should be able to go directly (or even overnight) from a failing bank to designing bailout packages to benefit such banks. In any other industry, in any other country, and at any other time in American history, this would have been seen as an unconscionable conflict of interest. Let’s get our principles back and impose a 5 year moratorium on such flows in either direction.

4) The way the Fed operates means that, in the absence of tough regulation, the finance industry has at its disposal the world’s greatest ever bailout machine. Our financial elite knows this and is acting accordingly.

Brandeis was scathing about the individuals behind the financial structures. For him, it was about power and it was about control. He was appalled by how big finance operated and he worked hard – an uphill slog – to rein it in.

But Brandeis never saw anything like what we have now experienced, with regard to the amount of taxpayer money that the banks are able to expropriate when downside risks materialize. The big banks that Brandeis feared did not, in the end, dominate the 20th century. But they are back now, with unfettered power and an arrogance that spells trouble.

Ultimately, we will put the banks back in their regulatory box or they will bankrupt us all.

Comments

[a fat panda:]

I am not sure why anyone thinks more regulation is the answer. Did regulation stop the GSEs from collapsing? These two organizations had virtually a private regulator which did nothing beyond regulate the GSEs. Regulation didn't do anything. Immediately before the crash, the REGULATOR signed-off on an increase in the limits on conforming loans. Even if you get competent regulators - in fact particularly if they are competent - the regulation will be removed in the hour of need just as Glass-Stegall was in 1998.

The solution is to let the market punish the managers who manage capital poorly. The market works well for widgets because the market punishes bad widget makers. The market has failed to work in banking because the market punishes the taxpayer.

Sep 15 10:18 PM

[tripleblack:]

Obama was on the tube again? Talking about Reform? Wow, that's never happened before...

Oh wait, no, it happens every day or so.

I feel like Crocodile Dundee, who flips on a television in New York, only the second such device he has ever seen in his life, sees the lead in for "I Love Lucy", and says "Yep, that's what I saw".

Unless they start having entertaining commercials like for the Super Bowl, I'm ignoring Obama's nightly Major Speech and waiting for the third (or is it #4?) autobiography to come out.

Sep 15 11:31 PM

[Poor Texan:]

Obama is an intellectual. As with most intellectuals, he's incompetent in dealing with average people. He talks well but after listening for a while, he doesn't connect. The critiques of his speech as disconnected and meaningless are valid. I wonder how many people, other than our media, even bothered to listen.

Sep 16 12:03 AM

[Moon Kil Woong:]

I only partially agree. The only thing that will make a difference is proper accounting meaning no off balance sheet accounting, fully evaluating derivatives liability, and a secondary report on mark to market assets values to coincide with the banks imaginary valuation numbers based on theoretical payment rates.

Without proper accounting any amount of regulation means nothing. We learned this with Freeddie Mac when we found out all their previous earnings were just deferred losses. It's amazing how everyone tolerates white collar crime. Just amazing.

Sep 16 03:29 AM

[Nyetnichevo:]

The banks and the government are hopelessly corrupt.
And that is why we are fast becoming a bankrupted, looted nation.
Trouble is where can an honest person store some wealth and savings? The henhouse is guarded by the wolves.

Sep 16 08:35 AM

[Brad Harper:]

So long as the conversation hovers about the superfluous angles presented by both the president and the author, i.e., "behaviors", owner stake, bank size etc., *nothing* will change.

Boom and bust is the reality of a mixed-economy.

Why is it that people only diagnose symptoms, but are oblivious to the root cause? The virus is government intervention in the market - all other complications are the logical results.

I can't imagine the incalculable wealth most of you guys could create if you applied your economic intelligence in the context of a free market. Instead, you waste productive energy analyzing a tangled web of regulations (SEC, IRS), over-complicated financial instruments, self-induced economic destruction (Antitrust, Federal Reserve) and aid in further destruction by perpetuating monstrous ideals (of the statist and Keynesian varieties) based on economic fallacies and all their manifestations.

Capitalism is dead.

Sep 16 08:56 AM

[crazyv:]

The problem with focusing on financial reform is that it places the cart before the horse and obscures the more serious problem that was the underlying economic rot that caused the financial crisis not the other way around.

The rising level of debt is a direct consequence of the fall level of wages. What needs to be examined whether the central tenets of economic policy supported by left and right are still valid any more.

Sep 16 09:08 AM

[Ned S:]

Obama is just one more mouthy American president. A spin doctor who reckons 4.5% of the world's population having 50% of the world's firepower and 23% of the world's GDP is good and would be way better if the GDP figure was 30%. Because Americans are such an enlightened and benevolent mob that remain inherently fit to lead the world. Despite every possible practical indication to the contrary. Which Americans seem to choose to believe. But noone else. Toodle pip America - I may not live to see it, but your days are numbered. This century will see you out. Asia's turn next.

PS: Old Joke - How do you you tell a politician is lying? His lips are moving.

Sep 16 09:28 AM

[terrymac:]

Why is no one talking about the elephant in the room? If some banks are "too big to fail", what about the biggest and baddest systemic risk of all, the Federal Reserve System?

Banks do such stupid and risky things because they are encouraged to do so by the Fed. If they run into trouble, Papa Fed will bail them out - that's the essence of the "Greenspan put."

Greenspan and Bernanke profess to be unable to tell when an inflationary bubble is in progress. I got a clue for you: when your grandma tells you that something is a great investment, it's a bubble. Better yet, when you're pumping up the money supply and driving down interest rates, you can expect a bubble. Duh!

The Fed is too big and too dangerous. It should be ended and replaced by a network of independent, competing banks which will never be bailed out. Those banks which make mistakes will die. Those which are prudent will succeed. That's what a genuinely free market looks like.

Capitalism without failure is like religion without sin: there is no incentive to do the right thing.

Sep 16 09:55 AM

[Gem Hudson:]

A rising gold price not only testify to its paper dollar. The paper dollar betray the paper stocks and it isn't worth the piece of paper that was printed upon. When the dow Jones goes down, there is not much demand and there is an over supply. Even tho the stock price are on an up trend. The dow Jones average from its 12,000 to 9,000 is on a down trend but the price of gold rise to an fallen dollar. The stock prices are kept high by first stuffing the banks with their paper money and then carry trade the loaned money. The supply side of their stock price goes up trend but the demand side of their down side is in the paper buying nothing more than paper.

An rising stock price to a fallen dow tell of a tale of a fix stock price and all this are playing with nothing more than funny money.

Sep 16 11:30 AM

[Plant the s...:]

The overwhelming need is for clear disclosure, not legal disclosure that puts the fine print so that everybody ignores it. No doubt people did abdicate their responsibility to research their purchase and were driven by greed just as much as Wall Street. For a frictionless purchase in any market both buyer and seller needs to clearly understand the benefits and risks before executing it.

Sep 16 11:32 AM

[Plant the s...:]

It seems that in any post mortem of this crisis, the lack of responsibility for someone in the system to be monitoring, publicizing and acting on emerging systematic risk is palpable. Every town does need a sheriff.

Sep 16 11:35 AM

[sapereaude:]

It is impossible to achieve economic stability in a closed system (Earth, for instance) by simultaneously increasing population and per capita consumption. Some underlying resources have a fixed and limited supply, and some nominally renewable resources will become extinct if they are not allowed time to reproduce and mature, or are harvested too aggressively. And that doesn't consider the effects of acid rain on the pH of arable soils or habitable ocean water, or of global warming on pernicious disease vectors, let alone inevitable Tambora events whose timing is unknowable.
That said, a few dozen public hangings of the most outrageously greedy bankers and corporate plutocrats might eliminate the fellatio of Mammon as a sacrament among urban financial creatures, and delay the inevitable catastrophe that must follow an economy based on steadily growing consumerism.

Sep 16 11:45 AM

[Howard_T:]

Here's a sure-fire way of regulating the largest banks. Convince the underworld mobs that they must put all of their assets into securities issued by the large financial corporations. Tell them also that if they suffer loss due to fraud that certain retaliatory measures will not be thoroughly investigated. When the first Wall Street banker shows up at the bottom of the harbor wearing concrete overshoes, the problem will disappear.

Obviously, I jest with the above. Too big to fail equates to being too big to exist. Reinstate Glass-Steagall and force all banks, regardless of size to break themselves up into separate brokerage houses and banks. These may be held under the same parent company, but must have completely independent management and direction. Abolish companies that do nothing but lend money to consumers. If any sort of fraud does occur, then punish it with fines and jail time (and not in a country club prison).

Obama's near-daily address is designed for more than one purpose. That is to keep his image of the beloved leader always before the public and to continually distract us from the ever-increasing shadow government he is carefully putting into place. (Check out the number of "czars" who were not appointed through the constitutionally required process of advice and consent, but have full authority to make and enforce decisions within their departments.)

Sep 16 11:59 AM

[Econ 101:]

Spitzer is in jail, set up because the parliment of whores saw this comming and didnt want a real sheriff around.


On Sep 15 04:28 PM ozzy wrote:

> The parliment of whores have come to the front of the line and are
> taking over. Where is Eliot Spitzer when you need him

Sep 16 01:11 PM

[SmartMoneyJoe:]

Obama has very different plans for his administration's tax policy. He plans on raising the highest marginal tax rates to 36% and 39.6%, they are now at 33% and 35%. This would return tax payers to rates they paid during the Clinton administration. Individuals making over $700K would see a raise in their yearly tax bill, while those making under that would see little to no change. Those making less than $250K would see a decrease in their tax bills up to $2,500 per year. Obama has also said he plans on raising both capital gains and qualified dividend taxable rates to somewhere between 20% and 28%.

Regarding public companies, in which we investors have a vested interest, Obama's tone is that of greater corporate responsibility. In regards to the financial sector, has said that he would require banks to have liquidity requirements to help avoid another Bear Stearns like collapse. Additionally he has stated the he would require more governmental oversight and give the Federal Reserve the power to further regulate any banking institutions to which it lends money.
------------------------
Look after your pennies, and your pounds will look after themselves.
www.personalbudgetinve...

Sep 16 01:34 PM

[John Lounsbury:]

Arianna Huffington had an Op Ed yesterday with a similar bottom line: Obama doesn't understand what he's up against. There is a link on my Instablog.

Unfortunately, the last president who both understood the problem and took effective action left office more than 100 years ago: Teddy Roosevelt. Maybe I should also include FDR, but I think Teddy R. is the best model. I think Truman and Eisenhower also had some recognition of the potential dangers of oligarchy and monopoly, but they were not reformative in that regard.

I can still hope that Obama may learn to understand and then react in a reformative way, but, nine months after his innauguration, I am discouraged. In the campaign of oligarchy, now that Capital Hill is bought and paid for, can the White House be far behind?

Simon - great article. I hope you can be heard in a few of the right places. Can corruption be reformed or will it just spread like terminal cancer?

Sep 16 03:45 PM

[alajac:]

The worse this gets, the better my plan looks.

The "Gordian Knot" Solution:

It's a take-off on Tom Paine's "Agrarian Justice", and you can find a more detailed outline of the plan on the "alan jacquemotte" profile page on classmates.com, as well as - under "alajac" - on u4prez.com and among my other comments here on seekingalpha.com.

HOW TO FIX THE ECONOMY (abridged version):

First, a commonsense definition of "government":
Government: "One or more persons who claim natural resources, are willing and able to defend their claim on those resources, and make and enforce decisions regarding the allocation of those resources."

1. Every government is the "de facto" owner of everything (including EVERYONE) within its domain; governments create "de jure" ownership in order to get resources into the hands they believe will be most productive and thus most conducive to the government's prosperity and longevity. Ever since the invention of the guillotine, government administrators have stopped claiming ownership of everyone and everything within the government's domain, but continue to act as if the ownership is a fact concerning which, like "Santa's secret identity", every mature adult is (or certainly should be) aware.

2. Regardless of who administers a government, the actual government (and, consequently, the actual owners of everything within the government's domain) is whomever the administrators SERVE (in the current instance, "a bunch of rich guys that own a bunch of banks and stuff").

3. In order to obtain ownership of the government (and thus, of ourselves) we need to get the government to serve our needs, first and foremost. And the first thing we will need to do towards that end (after we have taken over the administration of the government) is to replace Federal Reserve money with our own, backed by all the wealth within the government's domain (of which the government is the de facto owner).

4. Our first and pretty much only need (once the inequities created by the bankster regime are redressed) is for suitable compensation for government's impairment of everyone's right to free access to all land (see Paine's "Agrarian Justice" plan for cogent argumentation). All other forms of corporate and personal welfare and subsidies and free market interference need to be ended or phased out. No FDA or other corporate protection schemes, no Minimum Wage laws, etc.

[Before the "Cybernetic Revolution" began destroying most of the rest of the need for human labor that the Industrial Revolution missed, the "job system" of economic resource distribution (along with some Lockian BS) was adequate to mask the inequity of governments taking away everyone's right to free access to all land (an impairment that ALWAYS puts the capital-poorer at a bargaining disadvantage: due to the physical needs of human bodies, whoever has more capital is always further from homelessness and starvation, and thus always has a bargaining advantage over someone closer to homelessness or starvation who MUST, at some point, accept inadequate wages or else lose their home or starve to death), but now, like a runner who had a bad heart all along that didn't stop him until the final mile of the marathon, we find ourselves the possessors of a "bad economic resource distribution system". If we replace that inadequate economic resource distribution system with one that pumps out the same amount of economic resource "blood" to every "cell" (legal resident) and then lets those cells work and save or slack and waste as they will (in other words "pursue happiness" in whatever way they choose), we can create a totally stable economic system with no more "booms and busts", much less poverty and crime, no more "homeless vets", MUCH less excuse for government in general, etc.. The plan suggests impairment compensation of at least $1000 per month per legal resident (compensation for minors to be placed "in trust"); since everyone gets the same compensation there is no "redistribution" involved. Just to make sure we are clear: people will be free to work as hard as they like and make as much money as they like and spend it any way they like.]

5. All federal income-based taxation is to be replaced (ending the IRS's reign of terror) by a small, flat "infrastructure maintenance fee" on all electronic debit transactions, whatever is necessary (certainly less than one percent) to keep prices stable (keeping gold at a fixed price could be used as a measure). If you take out of a system (in a given time period) as much as you put in, there can be no inflation. The "infrastructure maintenance fee" (being charged as funds are spent) is directly related to "benefits already received", unlike the highly regressive federal income tax which charges kids just out of school a greater percentage of their accumulated wealth than many of the seriously rich and certainly all of the biggest corporations.

6. There should be one set of laws that applies to everyone equally: everybody gets the same, everybody pays the same, no special treatment for anyone.

Sep 16 05:34 PM

[untrusting ...:]

Moon,
What will make a difference, and the ONLY thing that will make a difference is prosecution and conviction - serious jail time and confiscation of assets. There are RICO laws and the Foreign Corrupt Practices Act. The RICO laws were intended for organized crime and drug trafficers, but they apply to fraud and corruption as well. When politicans, lobbyists, and public company executives including bankers are prosecuted and forced to pay a hugh price, then they may pull back ... but not until the price that has to be paid outweighs the gains they make. Fraud, misrepresentation, theft, insider trading, front-running, etc are illegal ... but that means nothing unless they are prosecuted and the consequences outweigh the rewards of attempting the activity.

Here's an idea that might just work. What we need is a major national fraud squad ... that is paid for performance. Let them have total supoena and prosecution powers, under the RICO laws ... and keep 25% of all assets confiscated after all expenses of prosecution and conviction. Maybe we can even do an IPO on this as a quasi-privatized arm of the Department of Justice. And since we as taxpayers support all the law schools in the country, perhaps we can start using the massive number of law school students as unpaid research interns for the new national fraud squad. Since the private sector is supposedly the great thing since sliced bread, let's turn the private sector into something that would help us all, a national fraud squad. Obviously the politicans, regulators, lobbyists, and big business are much too conflicted to accomplish something vital like fraud protection, so let the private sector do it for profit and we might actually get some results.

When you have some executives from Bank of America and Pfizer actually sent to jail and fined significant amounts of their personal wealth, then maybe just maybe corporate america will get the message and reign in some of their greed and fraud. After all this is the 4th time that Pfizer has "agreed to settle" on fraud charges. This time they are yet again admitting no guilt, but agreeing to pay $2+ billion in settlements. What difference does that make, when they can easily recover the paltry $2 billion with future fraud?


On Sep 16 03:29 AM Moon Kil Woong wrote:

> I only partially agree. The only thing that will make a difference
> is proper accounting meaning no off balance sheet accounting, fully
> evaluating derivatives liability, and a secondary report on mark
> to market assets values to coincide with the banks imaginary valuation
> numbers based on theoretical payment rates.
>
> Without proper accounting any amount of regulation means nothing.
> We learned this with Freeddie Mac when we found out all their previous
> earnings were just deferred losses. It's amazing how everyone tolerates
> white collar crime. Just amazing.
>

Sep 16 10:33 PM

[john s. gordon:]

without effective regulation we are lost.
brandeis was right.
> jack

Sep 17 07:51 AM