Reforming Financial Regulations

by: Zacks Investment Research

While most of the attention Wednesday was focused on Ben Bernanke's testimony before the House Financial Services Committee (not much new came out in that one, Ben says the recovery will be anemic, inflation will not be a problem and the Fed has a plan to drain the liquidity before it causes problems), the same committee held another hearing in the afternoon focused on the reform of the financial regulatory structure. Among the witnesses were Alice Rivlin, the former #2 at the Fed in the 1990's, Mark Zandi of Moody's Economics and Simon Johnson, the former chief economist at the IMF.

Among the key points that came out of it were that there were 2 basic approaches to preventing the need for future bailouts. One focused on better regulation particularly of those who are too big to fail, and the other is to make sure that institutions don't become too big to fail (TBTF). The Obama administration proposes to go down the first path.

It would be very hard at this point to unscramble the egg and reinstitute a version of Glass Stiegel. After all, one of the ways we dealt with the problem was going in exactly the other direction, with JPMorgan Chase (JPM - Snapshot Report) taking over the remnants of Bear Stearns and Bank of America (BAC - Snapshot Report) swallowing Merrill Lynch. There was general agreement that making the list of those institutions that are TBTF public would be a mistake. Those banks would have an implicit backing of the federal government, which would give them a very big competitive advantage by lowering their cost of capital. However, even if the list were kept secret, the market would pretty quickly figure out who was on the list (with a few big but not gigantic institutions left as question marks).

Since the best way to get big in a hurry is to take outsized risks, this approach could actually worsen the moral hazard problems and make future problems more likely rather than less likely. The odds are that the banks would move more quickly than the regulators (or simply capture them) and if the incentives are there where any winnings are kept private while the losses are borne by the taxpayers, the banks will head off to Vegas every time.

One solution would be to have the capital requirements on a sliding scale. Thus the bigger a bank is the higher the percentage of its capital that would have to be held in reserve, and that the FDIC insurance premiums would also reflect the higher systemic risk that very large banks pose. This is a very good idea. It would give banks an incentive not to get too big. If they were successful and grew, they could always spin off divisions to their shareholders to make themselves smaller, and thus have lower capital requirements.

There was disagreement over the Fed being the best agency to serve as the systemic risk regulator. Clearly it did not cover itself in glory as a regulator in the lead up to the financial crisis (there monetary policy reactions to the crisis on the other hand were excellent). However, there are no clearly better placed alternatives and they already do have some regulatory functions. Assigning it to a committee of different agencies would be a recipe for disaster, with no clear lines of responsibility. Some expressed concern that it could lessen the perceived independence of the Fed, but I do not see why that would have to be the case.

Most of the participants strongly endorsed the idea of a financial Consumer Products Safety Commission. I whole heartedly agree. It, however, is likely to be fought tooth and nail by the bank lobby. To my mind, that is proof enough that it is desperately needed.

The existing regulatory structure has been a dismal failure at protecting the consumer from abusive mortgage and credit card contracts (go ahead and pull out your credit card contract, I defy any reader to understand what it says, with the possible exception of a lawyer who specializes in that area).

Protecting the consumer will always be an afterthought at agencies like the Fed. The top officials, and brains, there are going to be focused on monetary policy, not on making sure that plain vanilla mortgage products are available at all institutions that offer mortgages. Standardization of plain vanilla financial products would also help the smaller banks since it costs a lot of money to write 35 pages of fine print legalize, which a big bank can spread over millions of customers, but a small community bank could not hope to do.

While this seems like a technical and complicated issue, it is important to keep the heat on congressmen and senators to make sure that the Consumer Safety Commission comes into existence, otherwise the lobbyists will kill it in its crib.

After all, even after Sinclair published "The Jungle", the meat packing industry fought for the right to sell rancid meat to consumers. You can bet the banks will fight for the right to sell rancid mortgages a century later. They will claim that it will kill off innovation, but really, how much benefit have we gotten from innovations like option-ARMs and exploding subprime loans than get packaged into CDO squared? Wall Street reaped massive bonuses from those innovations, but could someone please explain to me just how an ordinary consumer benefited?