Memo to Senator Dodd: Financial Reform Need Not Be Complicated

In response to Senator Dodd's proposed bill - which uses a lot of buzzwords that sound like reform, but really just maintains the status quo - several writers have forcefully argued that we need to focus on the actual purpose of banking.

As a number of people have pointed out, any bill which is 1,136 pages long will contain loopholes big enough to drive a truck through. Almost no one will actually read the bloody thing, those that do will see that it is rife with ambiguities. And it will get so marked up by the time that it works its way through various committees that - by the time it is passed - there will be more holes than swiss cheese.

Unless financial legislation addresses the big picture - why do we have banks and what do we want them to do - nothing will really change.

One blogger sums up the big picture argument pretty succinctly:

I worry though that — despite the healthy impetus and rhetoric [in the Dodd bill] — that the center of thought on all this seems stuck in the same equations, theories, ideas and general zeitgeists about efficiency and all that. Just a bit of big-time tweaking is all we need... But a new coat of paint on a rotting wall will eventually chip and crack.

No, we need to make them really think. Let’s have a “Preamble” to this legislation, like the Bill of Rights is to the Constitution, that sets up the Philosophical ground. What’s a bank for? What’s a financial system for? What is the public good?

I have repeatedly written that Glass-Steagall should be reenacted, and that banks should choose either to act as traditional, safe depository institutions or as speculative funds, but not both. I have also

argued

that companies which extend credit should be treated like public utilities. But the above-quoted blogger hits the nail on the head with very few words: we need to focus on the overall purpose of the banks and the financial systems.

And fund manager Marshall Auerback provides a detailed proposal for a public purpose test:

We feel that the ‘race to the regulatory bottom’ could easily be solved via a simple mechanism: If you don’t fall in line with our regulatory requirements, you’re simply denied a banking license to operate in this country. Problem solved. The United States is the biggest banking market in the world. Do you think any major bank would willingly vacate this market?

And even if the “too big to fail” behemoths decided to transplant a bunch of their operations elsewhere, the country would still be left with thousands of community banks which could fill the void and better fulfill the public purpose described by Mr Blankfein: namely, to “help companies to grow by helping them to raise capital”, rather than extracting their pound of flesh via grotesquely high financial intermediary fees, as is the case today...

WHO controls the banks is ultimately less important than HOW we control the banks’ activities. Oversight is all very nice, but at times it pays to get back to first principles. What on earth is the public purpose of these things?

Banks are set up and supported by government for the further benefit of the macro economy via providing a payments system and lending in a way that is specifically defined by regulators. Newsflash: the public purpose of banking is NOT to provide profits per se to shareholders. Rather, the provision of the ability to earn profits is only a tool used to support the attendant public purpose. Banks should only be allowed to lend directly to borrowers, and then service and keep those loans on their own balance sheets. There is no further public purpose served by selling loans or other financial assets to third parties, but there are substantial real costs to government in regulating and supervising those activities. There are severe consequences for failure to adequately regulate and supervise those secondary market activities as well.

Banks should be prohibited from engaging in any secondary market activity because it serves no public purpose and may result in severe social costs in the case of regulatory and supervisory lapses. Some argue that these areas might be profitable for the banks, but this is not a reason to extend government sponsored enterprises into those areas. Therefore, banks should not be allowed to buy (or sell) credit default insurance. The public purpose of banking as a public/private partnership is to allow the private sector to price risk, rather than have the public sector pricing risk through publicly owned banks.

If a bank instead relies on credit default insurance, then it is transferring that pricing of risk to a third party, which is counter to the public purpose of the current public/private banking system. Banks should not be allowed to engage in proprietary trading or any profit-making ventures beyond basic lending. If the public sector wants to venture out of banking for some presumed public purpose it can be done through other outlets.

If the activities of the banks are not facilitating the production and movement of real goods and services what public purpose do they serve? It is clear they have made a small number of people fabulously wealthy. It is also clear that they have damaged the prospects for disadvantaged workers in many parts of the world.

It’s more obvious to all of us now that when the system comes unstuck through the complexity of these transactions and the impossibility of correctly pricing risk, the real economies across the globe suffer. The consequences have been devastating in terms of lost employment and income and lost wealth.

All governments should sign an agreement which would make all financial transactions that cannot be shown to facilitate funding for real goods and services illegal. Simple as that. When we keep these principles at the front of the argument, we can see that what Senator Dodd and Congressman Frank are arguing about is akin to how to rearrange the deck chairs on the Titanic.

Comments

[MyrEnforker:]

Great article. Let's back to banking for the public good instead of good of the bankers.

Any organization that is allowed to borrow from the fed (which SHOULD be acting in the interest of the public) should do with the understanding that they are following strict guidelines with regard to lending TO the public.

If they don't follow those guidelines, THEY CAN'T BORROW OUR MONEY!

Nov 11 02:14 PM

[bobbybutte:]

great article lets make a simple bill

with 3 lines

1) reinstate glass steagal

2) all loans must be held a miumum of 6 years before being sold

3) congress needs to stay out of capitalism and quit thinking everyone should own a home

Nov 11 03:09 PM

[woollyB:]

Glass-Steagall was passed in 1932-33 (actually 2 acts) to prevent the market crash of 1929, and it was repealed in 1999, just in time for the next big turn down. If we reinstate it in 2010 to prevent the crash of 2008, we'll end up repealing it again once we get into a long enough uptrend for everyone to believe that the Act is inhibiting growth and profits.

P.S. to MyrEnforker, when was banking ever for the public good? Not in any banking history I've ever read.

Nov 11 03:25 PM

[THofler:]

Have any of you geniuses ever heard of hedging? In many, but definitely not all, cases this reduces the risk in a business like lending money. And if I'm not mistaken, nearly all hedging occurs by trading securities.

Clearly, the Basel II regs. were intended to connect capital reserves with a mathematical determination of a bank's risk level. And what a disaster that was! (Thanks Moody's et. al.) But that doesn't change that fact hedging DOES work, if your intent is to hedge and not gamble. We need regs. that allow the former and not the latter.

Nov 11 04:02 PM

[ebworthen:]

I have observed politicians and the process for over 30 years.

There are no words, debate, bill or resolution that will end the lies, equivocation, and tyranny.

We are building up a societal tension, a compression of lives and fortunes, that will explode into massive violence.

It will come as surely as an earthquake eventually does from the grinding together of tectonic plates.

It is so sad that our leaders haven't been able to be adults and make the right choices for all of us rather than simply serve themselves.

Nov 11 07:30 PM

[chris coonan:]

From what I understand, Senator Dodd is part of the Old Boy Network with his hands directly on the puppet strings....so he might not be the best one to be putting Reform agenda forward.

Nov 12 03:47 AM

[chris coonan:]

Old Boy Network (OBN)....trading at higher P/E levels today.

Nov 12 03:49 AM

[chris coonan:]

If there is one thing I hate....buzzwords....I can't imagine a document with 1,136 pages of them. Can't be good.

Nov 12 03:52 AM

[ScroogeMcduck:]

You won't get financial reform until you get government reform.

Nov 12 12:15 PM

[robert.b.fe...:]

Thank you great article. Your blogger was absolutely correct. I have argued here before that Glass/Steagall should be reinstated and that the creditor/debtor relationship should be maintained with the originator of the loan and the borrower. Derivatives were created originally to mitigate risk incurred by coerced bad loans forced on banks by the CRA. We, all of us, collectively and separately must realize that home ownership is not a right to be given to you by the government. There is no such thing as economic or social justice based upon redistribution of wealth. Whenever some one gets some thing for nothing some one else gets nothing for some thing. If we create a government powerful enough to give us everything we want we will have created a monster capable of confiscating every thing we have.

Nov 12 06:01 PM

[MyrEnforker:]

Great comment by WoollyB.

"P.S. to MyrEnforker, when was banking ever for the public good? Not in any banking history I've ever read."

You are correct in the answer is never. That is just my pipe dream. Anybody who knows anything about history knows that the Fed was originally created to profit the bankers of that time.... ; )

In retrospect though, it does have its upsides. It spurs 'over'production which may help in advancing technology faster, adding to military might (we've DEFINITELY used this one), etc. It allows to do everything faster, but at extreme risk of burning out - which has definitely happened at multiple times.

The big question is whether it helps overall. Answer: Depends on your goal. NOT needed for a happy, healthy life. Definitely needed if in competition with other countries with regards to technology and/or war. I think the politics of the modern era demand at least some level of banking and leverage to establish superiority in advancement.

Nov 12 11:15 PM

[MyrEnforker:]

Just a quick question for all the folks on this reading this article.

I can understand how derivatives MIGHT be a good thing if used to pass on risk on an existing position to a 3rd party who is willing to take on that risk.

My question is that wouldn't selling the risky asset and buying a less risky asset achieve the same objective without all that 'friction' in the middle?

EX: I have an investment that makes me 15% a year, but I feel the risk is 8% chance of failure. Market is currently returning 3%, so 12% of additional return is wedded to the 5% chance of additional failure risk. Now I think "This is too risky".

Why not sell it and purchase something risk appropriate rather than purchase something that brings you down to that risk level. Is the market not liquid? Can you make more money buy buying the derivative (in which case the middle man is an idiot)? Ease?

Nov 12 11:23 PM

[derryl:]

If the socially useful purpose of banking is to serve the public's interest then banks should not hedge out their risk. Who would take the risk? Other Americans? Foreigners?

The CRA and securitization (which can be seen as a way for banks to offload the risk of the bad loans they made and thus "hedge" them) increased the total quantity of risk in the system as a whole. If you put risk into the system, the system as a whole cannot shed that risk. By offering a hedge against banker risk you simply introduce moral hazard into bankers' incentive structure which will induce them to make more risky loans than they are willing to hold on their own balance sheets. Banking should be "narrow". Bartering risk is poker, not banking.

Nov 13 12:34 AM

[prudentinve...:]

The only "regulations" we need are:

(1) Public should not bail out any failed private enterprise. If its failure threatens our security, it should be nationalised with its shareholders losing out and its bondholders taking a haircut. This is what gov't did with GM & Chrysler, and this is what should have been done with any bank, no matter how large. No amount of regulation will work as long as the upside goes private and the downside goes public.

(2) Stop manipulating interest rates and let markets set them based on equilibrium between willing lenders and borrowers.

(3) Institute an "Alternative Maximum Tax" that ensures creative entrepreneurs, the true engine of our economy, don't choose "early retirement" and "spend more time with family" ......, when they really mean "I've earned enough money, and the incremental after-tax income is not worth the extra effort" !

Capitalism and free markets have brought us prosperity, and the only "regulations" we need are to stop distorting them.

Nov 13 07:41 AM

[prudentinve...:]

Perhaps it will prevent the crash of 2012!


On Nov 11 03:25 PM woollyB wrote:

> Glass-Steagall was passed in 1932-33 (actually 2 acts) to prevent
> the market crash of 1929, and it was repealed in 1999, just in time
> for the next big turn down. If we reinstate it in 2010 to prevent
> the crash of 2008, we'll end up repealing it again once we get into
> a long enough uptrend for everyone to believe that the Act is inhibiting
> growth and profits.
>
> P.S. to MyrEnforker, when was banking ever for the public good? Not
> in any banking history I've ever read.

Nov 13 07:45 AM

[BlueOkie:]

One may not understand politics but everyone understands when a bank defaults. We need to reform Congress as well as the banks.

Nov 13 09:02 AM

[Snitzer:]

One must deal with the situation as it is, not as they wish it was. The global governmental/financial hydra-headed monster is so tangled up with millions of special interests hyping their own little versions of financial, ideological, theological and social nirvana that no one person or group can untangle the poisonous Medusa like threads and reweave it into anything resembling sanity. Rome did not fall in a day, a year or even decades, but Rome did fall, leaving behind a rich set of help files in how not to maintain an empire. America is not the evil empire, all of the world's industrialized nations can be seen as being in varying states of decadent free fall, and in time the hungry survivors of Modern Man will be roaming the Asian steppes, searching desperately for food and avoiding the radioactive remnants of our once great societies.

On the other hand, if we get into space travel, there will be whole galaxies there for the taking, and we can write this story over and over, right on up till the final super-nova blows us all into component atoms.

Bound to be some rather attractive investment opportunities in all that.

Nov 13 02:37 PM