Financial Regulation: How Would You Have It Work?

On Monday, myself and several other financial bloggers got the chance to meet with several senior Treasury officials, including the Secretary himself. It was a fascinating experience and I have to admit, it was just plain cool to be within the bowels of power like that.

I am also on record as saying that Geithner was a good choice for Treasury secretary. We needed continuity as the bailout process was on-going. Geithner knew exactly where the bodies were buried in a way that other choices, such as Summers or Goolsbee wouldn't have. I have since come to view Geithner as a pragmatist, which I appreciate in anyone elected from the other party. And truth be told, a lot of the Treasury department's plans are working. I can't deny that. I panned the stress tests when they happened, but I can't deny that it worked. It created confidence where there was none. Say what you want about whether or not banks are still in trouble, I'm not terribly confident, but we're sure a lot better off today than January 19.

All that being said, I don't think much of the Administration's attempt at improving bank regulations, and I told them so. I even managed to do it politely without lacing in a Star Wars quote. Here is my main beef. I will explain myself in classic Accrued Interest style: very very long form.

The Administration's new regulatory scheme seems to focus on reducing bank risks. Higher capital requirements, more disclosures, etc. That all seems fine, except that is it really fundamentally different than what we have now? That is isn't it just an expansion of the same basic regulatory scheme that currently exists?

And if it isn't fundamentally different, does increased capital really solve anything? Citigroup (C) had a large percentage of its risks off-balance sheet. Lehman's (LEHMQ.PK) capital ratios were nominally quite strong on Friday, bankrupt on Monday. Both firms had adequate capital, and both either did or should have failed.

When this was pointed out to certain senior Treasury officials, their response was basically that they won't allow those sorts of games in the future. They were closing the loopholes that Lehman, Citi, and countless others exploited to hide their true leverage. I respond that even if you stop the games that banks were pulling in 2008, won't the banks come up with different games in the future?

The reality is that even if we do nothing, we might not have another financial crisis for many years. Let's say it's 2022. Let's say we've just gone through 6 years of tranquility in the financial markets. Let's also say that banks have come up with some new and creative security where they get to keep all the upside with 85x leverage, but by the existing banking regulations it shows as a fully cash funded position against the bank's capital. Will bank regulators be motivated to ban this new security? I doubt it. Why do I doubt it? Because current regulators around the world looked the other way at CDO^2. Regulators aren't going to have the courage to challenge the banking industry during a period when the banking industry seems to have been right.

For the same reason I reject the notion of "regulatory supervision." Not to say that I think regulators are nefarious people, but are they going to understand the risks as well as the bank itself? And if the bank has a good reputation for taking risks, will regulators challenge them? Bear Stearns was known as the best mortgage shop on the street. Let's say you gave regulators dictatorial power, they could do anything they wanted. Would an omnipotent regulator have told Bear they were taking undue risks? Or would Bear have explained their positions, the regulator not understood them and assumed Bear was smart enough to handle it?

Transparency isn't a panacea either. Do you really think you are going to fully understand the risks at Goldman Sachs (GS)? As Yves Smith said Monday, you'll never have Goldman revealing their trading book. And even if you did, it might not tell the whole story. By the time the disclosure is published, their positions might be different. So what do you do? Put risks into categories? Like what? Credit ratings? We saw how well that worked! More transparency is better than less, but I'm asking the reader to be realistic about how much we're really going to know.

I'm a free market guy. I'd like to see any business be allowed to take whatever risks they can get funded. I don't want to tell what risks banks can take any more than I want to tell Macy's (M) how many stores it should open or what flavor ice cream Coldstone should be selling.

Yes, I know. Coldstone isn't J.P. Morgan (JPM). But why not? Only because J.P. Morgan's failure has major consequences for other banks. But in a perfect world, we'd let J.P. take whatever risks it thought would make them money. That is, whatever risks the market would fund by buying J.P.'s debt and equity instruments. And if J.P. failed, then those investors would get burned.

Notice that this world wouldn't require regulators to predict where the next crisis would come from. It wouldn't even require banks to hide their leverage. The relative risk of a bank would be reflected in their cost of capital. If one bank was more aggressive than another, it would have to pay more for capital. I know, it sounds so idyllic, it can't be possible, right?

I argue that the only reason why it isn't possible is because we can't deal with a large bank (or insurance or brokerage) failure in isolation. There is always contagion. But there doesn't have to be. What if government regulation was aimed at limiting contagion post failure? It might be somewhat complicated and it might not completely eliminate all moral hazard, but it's doable. Say that the government set up an FDIC-style insurance pool for over-the-counter derivatives and prime brokerage. Think of how radically different the AIG and Lehman failures would have been if no one was worried about having to face a bankrupt firm in a derivatives contract!

Like deposit insurance, I'd argue that such a regime wouldn't necessarily be costly to the government. Just like deposits, it's likely that any firm's derivatives book could be sold to another firm, maybe at a loss, sure. It would be all the more easy so set up such a system if the more plain-vanilla derivatives, like interest rate swaps and most CDS were exchange-traded.

I know what you are thinking. Basically I'm saying to forget about preventative medicine and treat all patients only once they are in the ER. The problem is that regulation has done an absolutely horrendous job of preventing every crisis to date. Why do we think it will work this time? In fact, Yves Smith argued with me Monday night that the Basel II regulations, which are heavily credit rating oriented, helped to fuel the rise of the CDO. I agree completely. Where I disagree is the notion that a different regulatory scheme will somehow produce different results. I expect banks to do what they are incented to do.

We're seeing it already. Banks are loading up on Treasury bonds anticipating that those will get more favorable regulatory treatment in the future. Are we fueling a bubble in Treasuries? Maybe not, but the point is that regulation is inherently distortive. Replacing the old regs with new regs isn't going to change that simple fact.

So yes. I'd rather the government get out of the prevention business and get better at unwinding complex and systemically important financial institutions. It was really cool that I got the chance to tell Treasury just that. I don't know that it's actually going to make a difference. But it was cool anyway.

Comments

[Tom Armistead:]

Bernanke has mentioned a number of times that the current regulatory regime is pro-cyclical, and suggested that this be changed. That would mean that capital requirements would go up in times of economic tranquility and down in times of stress. The Fed could have a target capital ratio and raise or lower it in judicious .25 point increments, with much fanfare and a carefully crafted statement for the press to parse.

There is no reason why CDS should have been allowed to be exempt from regulation and there is no reason why naked CDS should be bought and sold at all. Lehman would still be standing if CDS had been properly regulated rather than permitted as a casino on Wall Street.

Speculation by "banks" and others in the various markets could be supressed by setting punitive margin requirments in order to reduce leverage. Again the Fed could review the margin requirements frequently and change them incrementally with much
fanfare.

Banks could go back to accepting deposit and making loans, and the whole array of speculative and manipulative trading they are premitted to perpetrate on the investment community could be made illegal.

Nov 05 07:37 AM

[Shaftsinker:]

"The problem is that regulation has done an absolutely horrendous job of preventing every crisis to date. Why do we think it will work this time?"

It works in Canada. In fact it worked absolutely flawlessly under the most turbulent conditions imaginable. Just saying.

It doesn't work in America because it's meant to not work in the first place.

Nov 05 08:39 AM

[john s. gordon:]

'closing the loopholes'.
full speed ahead please.
although the banksters are very proficient at inventing new loopholes.
eternal vigilance is the price of financial stability.
> jack

Nov 05 09:01 AM

[Mr. Big:]

It worked in Canada...that's true. But it's not effective financial regulation. The whole culture of borrowing is very different.

You see, in Canada, 25% downpayment on a home with 75% financed by mortgage borrowing is typical. Any amount of borrowing that is more than 75% of the value of the home must be fully insured. Also, tax writeoffs on mortgage interest payments do not exist in Canada. That forces Canadians to be more prudent with the price of homes they choose and provides incentive to pay down mortgage debt as quickly as possible.

Canada's culture of prudency, in addition to effective regulation designed to PROTECT Canadians helped the banking system stay healthy, strong and profitable.

The U.S. is quite the opposite. Americans have a culture that encourages borrowing. Financial regulation over the past 15 to 20 years was more designed to focus on efficient markets and fair competition. Consumer protection was lower on the list.


On Nov 05 08:39 AM Shaftsinker wrote:

>
> It works in Canada. In fact it worked absolutely flawlessly under
> the most turbulent conditions imaginable. Just saying.
>
> It doesn't work in America because it's meant to not work in the
> first place.

Nov 05 10:26 AM

[Mr. Big:]

To build on my previous post, the solution to the credit crisis is not only regulation. The whole culture of borrowing and lending in America must be analyzed and changed from the ground up. In general, consumers cannot be relied upon to be prudent by themselves. We've proven, time and time again that greed will rule the day and that the fast and easy road (i.e. borrowing and spending) will always be taken. This is the fundamental nature of pure capitalism. Consumers can only be made prudent through the policies and financial framework set by the government and the regulating bodies. If the framework encourages borrowing, that's what consumers will do. If it encourages savings, that's what they will do.

Most of us probably will agree that the concept of pure capitalism fails because it is guided only by greed. Classic game theory is always in play. I'm not saying we abandon capitalism. I am saying, however, that we put bounds on capitalism. And that means putting rules in place:

1) Separation of retail banking and investment banking
2) Establish regulation (policies and guidelines) of hedge funds
3) Setting a cap on the relative size of companies (if it gets to big, parts must be spun off as separate stand-alone entities)
4) Close tax loop-holes that result in hundreds of billions of tax-benefits to complex multinational corporations.
5) Phase out tax-benefits on mortgage borrowing
6) Mandate insurance on mortgages greater than 75% of the value of the collateral.
7) Establish mandatory congressionally appointed audit reviews of the Federal Reserve and the SEC as well as the credit rating agencies.
8) Enhance review and regulation of complex structured derivatives. Mandate enhanced liquidity and collateralization requirements on these products.
9) Increased regulation of credit default swap market
10) Enhance rules and establish policies of intervention (by Government or regulatory bodies) around excessive speculative activity.
11) Boost tax incentives for retirement savings (finally....rewards for prudency)

etc...etc...etc...

These are but the tip of the iceberg....

But what I'm alluding to is the need for a complete overhaul of the capitalism model from the ground up.

Nov 05 11:17 AM

[Techtrader10:]

The was a great law in place that was removed during the Clinton Admiinistration because it was said to "hinder" the banking industries competitiveness. The Glass Steagall Act was a way to separate the banking and investment firms. It was a good idea and should be reimplimented.

Nov 05 11:57 AM

[Silentz:]

On Nov 05 11:17 AM Mr. Big wrote:


> But what I'm alluding to is the need for a complete overhaul of the
> capitalism model from the ground up.

We may need to overhaul OUR version of capitalism, which isn't really true capitalism anymore, but if allowed to operate freely, our economy would be just fine. I believe the true solution is to allow for regulation of markets to prevent outrageous abuses and to keep things relatively safe, but then get the government out of every other part of the marketplace. No more social policies, no more market manipulation, and no more redistribution.

A free market may not always be 100% fair, but neither is what we've got now. It's a fact of life that some will always have more than others. You may feel that that's not right, but it's also not right to take what a person has earned simply to give it to someone else that "deserves" it because of their genetic makeup, life choices, or circumstances of environment.

I agree with most of your points, but there's a point where too much regulation and manipulation causes more problems than it solves. That's where we are now.

Nov 05 01:50 PM

[dw57:]

well that was engineered by one person. Phil Graham. and he isn't a democrat


On Nov 05 11:57 AM Techtrader10 wrote:

> The was a great law in place that was removed during the Clinton
> Admiinistration because it was said to "hinder" the banking industries
> competitiveness. The Glass Steagall Act was a way to separate the
> banking and investment firms. It was a good idea and should be reimplimented.

Nov 05 03:24 PM

[THofler:]

Larry Summers was a big supporter of the repeal of Glass Steagall act when he was in the Clinton White House, as am I. I do think the size of the investment book for a depository bank should be capped with some hard limit.

Worse, was the commodities and futures (CFMA?) bill that Gramm helped push through. This led to the excesses in the CDS market.

Nov 05 08:13 PM

[Moochacha:]

Suggestions:
mortgages be held by the banks or companies that write them, and they would be more careful of who they lend to, but instead they prefer to take a "hair cut" and sell the mortgages in packages to investors or other mortage lenders.

Ratings on Mortgage backed securities should be done by companies by looking at the actual mortages and should be insured, not swapped.

Servicers who process payments should not get fees when mortgages are in default and should be accessible by the holders of the mortgages, etc. as well as the mortgagees. Preferably the mortgage lenders should also be the holders and servicers.

Nov 06 07:16 AM