No matter how well the Obama administration and Congress design our financial regulatory structure if our regulators perform poorly the risk of failure is great. Conversely, good regulators can overcome a weak system. The collapse of our financial markets last fall—with worldwide reverberations—could have been avoided had the regulators operating within the existing system during the Bush years not been largely devotees of a libertarian, the market-takes-care-of-itself ideology.
The American public must bear this important point in mind as they and their representatives in Congress consider the Obama administration’s 88-page outline of its plan for regulating financial markets, which was released yesterday There is a long way to go and the devil will be in the details of the legislation that needs to be drafted to implement most of the administration’s plan. What emerges will likely be a structure that we live with for the next 50 years, or until it proves itself a failure. So getting it right first crack is important.
Getting it right is hugely important, but it’s also important to get it right reasonably quickly. The tragedy of the collapse of our financial markets and credit markets is not that well-off investors and highly compensated Wall Street executives have had their comeuppance. The mostly soft landings they’ve experienced stands in sharp contrast to the hard landing of our economy, which relies on these markets serving important roles in fueling the investment and spending that keeps the economy moving and offers people the opportunities of employment, homeownership, credit, and savings.
Even before the financial collapse we had a problem. We had the illusion of a financial sector doing its job. But in fact it was mainly financing a huge asset bubble. Regulatory reform isn’t just about getting the mechanics of markets back to a normal mode of operation. Well-done reform will also create a system that puts the brakes on the sort of financial engineering that creates the illusion of economic growth but not the real thing. Full economic recovery, and ongoing growth, cannot be achieved until these markets are fully back at work supporting productive investment.
To do this we need to restore the confidence of investors—domestic and international—in the integrity of U.S. markets. Investors need to know our house is in order, that the investment risks they face will be those that are calculable in a well-regulated market, and that they need not be paralyzed by fear of being blindsided from a systemic collapse.
Investors also need to have their faith restored in some of the basic tools that markets rely on. Without reform it’s going to be a long time before wise investors place much faith in credit-rating companies and professional guidance from the financial services industry. Nor are many going to be willing to put their trust in black box models developed by Wall Street’s mathematical geniuses.
There is a better way to be protected than by the safety of an inactive financial market.
In many ways this skepticism is a good thing—it represents an appropriate reaction, albeit a tad late, to the consequences of the financial sector meltdown that began two years ago. But there is also the risk that this natural pulling back will result in an economy hindered by the fear that the financial system remains devoid of integrity—that it can’t be trusted. An inactive market is a safe market—if not much is happening, not much bad is happening. But an inactive market is not good for the economy, good for jobs, or good for growth.
There is a better way to be protected than by the safety of an inactive financial market. That better way is to create a regulatory structure that puts in place protections that serve the economy both by preventing a repeat of our recent experience and by restoring confidence in fundamental verities that are needed as a foundation to well-functioning markets. The sooner this happens the better for bringing our economy back to life for the benefit of all.
In addition to restoring trust to spur the economy, another reason for moving quickly is the political dynamic. Moving major legislation in Congress is always difficult, but doing it without a news hook or a real world imperative makes the task Sisyphean. The longer the issue languishes the more the media and the public will have their attention diverted and the greater sway those with narrow interests will have over those who care more about a system that is best for the economy as it serves the common good. The time is now.
The Obama administration’s proposal is a good place to start. It appropriately focuses attention on systemic risk, protecting consumers, making regulatory responsibilities more clear, and changing several private market incentives so that our financial institutions act more responsibly.
One of the critical challenges that came out of the crisis is how to deal with too-big-to-fail institutions. These are financial corporations so embedded in the economy and boasting so many interconnections with other market participants that if they collapse they bring a good part of the economy down with them.
Since this is an untenable outcome, the federal government, as we’ve seen, has had to come to the rescue of these institutions. The ad hoc rescue of gigantic failed private institutions is a less-than-ideal approach. First, it’s very expensive for taxpayers. Second, the rescues themselves actually make things worse prospectively because institutions that are likely to be bailed out if they get into trouble are more likely to take on greater risks—making failures even more likely (a phenomena known as “moral hazard”).
A key feature of the administration proposal is assigning the Federal Reserve the authority to impose more stringent requirements on large financial institutions—such as more comprehensive risk management and maintaining larger reserves against losses—than are required of smaller institutions. The idea is that institutions that can’t be permitted to collapse should have special requirements on them that make their collapse impossible.
Although the Fed is to consult with a council of regulators, the plan is heavily dependent on the Fed’s good judgment on when to impose such requirements and how strict to make them. The administration is right to assign the responsibility to one institution with which “the buck stops” instead of making it a collective responsibility. But given the Fed’s mixed record as a regulator and shepherd of the economy, and its history of secrecy and lack of accountability, this aspect of the plan will get a very close look by Congress.
One of the critical challenges that came out of the crisis is how to deal with too-big-to-fail institutions.
One alternative approach to the problem of too-big-to-fail institutions would be to effectively ban them by mirroring Depression-era rules that erected walls between different types of financial businesses. The idea of this type of regulation is that it prevents a banking crisis from becoming an insurance crisis, a mortgage crisis from becoming an investment banking crisis, and an investment banking crisis from becoming a money market crisis, and insurance industry crisis and eventually a corporate finance crisis—as happened with stunning rapidity last fall.
There are, however, challenges to recreating walls between the activities of various financial institutions in a modern economy. One is that because there are many financial practices now that blur the lines between different financial sectors it’s difficult to break down the dependencies between sectors—even if functions are divided between different institutions. Case in point: The securitization of debt, which results in bundles of loans being packaged up together then sliced and diced and sold in pieces to institutional investors worldwide, combined with even the most appropriate hedging transactions, crosses such boundaries. In short, one could break up individual financial institutions but if the markets they operate in all go up or down together, it doesn’t do much good.
Another challenge to breaking up the too-big-to-fail institutions is that there are now financial transactions conducted on the global scale that require very large institutions. Driving such transactions away from the United States, or effectively requiring multiple institutions to collaborate for transactions to move forward, could be counterproductive. Although one can imagine steps that could be taken to mitigate the challenges to returning to a more Depression-era approach, they would be complex and the Obama administration decided to eschew such a politically extremely difficult path.
There are, however, approaches that lie between being completely dependent on a forever-well-run Fed and putting strict, inviolable limits on financial institutions that are deemed essential to the economy. For instance, Congress could consider an insurance model such as that used by the Federal Deposit Insurance Corporation but broadened to cover a broader range of liabilities beyond deposits, or perhaps less discretionary capital reserve requirements. Such approaches do pose the risk of being poorly calibrated to market conditions at any particular point in time. But there’s no guarantee that the Fed will get it right either.
More formulaic approaches such as these have the virtue of being predictable, free of the failings of a particular regulator, and not susceptible to the politics or irrational economic exuberance of a given moment. Another protection would be greater public availability of information about the workings of financial institutions. The regulators have to be the primary line of defense, but the availability of information to outside analysts can provide a good check on their work. If we’re not breaking up these too-big-to-fail institutions, then we ought to have protections against falling into the same traps of the past if a future Fed fails once again to regulate them properly.
There are challenges to recreating walls between the activities of various financial institutions in a modern economy.
The reform that might prove to be of the most immediately apparent value to most Americans is the administration’s proposed creation of a Consumer Financial Protection Agency. The consumer-protection responsibilities of the existing patchwork of financial regulators have often gotten short shrift. At the Fed, for instance, monetary policy has come first, the safety and soundness of institutions has come second, and consumer protection a distant third. While that may appear to be a problem primarily for people with mortgages and credit cards, the mortgage crisis might have been averted had closer attention been paid to issues such as predatory home mortgage lending.
Subprime mortgages, many foisted on people who could have afforded better terms, proved not just bad for the borrowers but destructive to the financial system as well. The proposed creation of standardized, easy-to-understand loans would be welcome by consumers—even as more exotic instruments subject to greater regulatory supervision would still be available for those in special circumstances who would benefit. It is important that this new agency has the independence and teeth of its regulatory kin charged with ensuring the solvency and sustainability of the institutions and overall financial system.
The package offered by the administration has many other provisions of note such as closing gaps in the regulation of new forms of financial institutions and instruments (including credit default swaps). It also has proposals to change the incentives of market participants. Credit-rating agencies, for example, will have to be clearer about the logic behind their ratings, what risks they haven’t accounted for, and their conflicts of interest. Lenders will be compelled to retain some of the risk of the loans they make, not fob it all off on ill-informed investors. And compensation practices at financial institutions will be changed to deter the “quick-buck” mentality that contributed to the current crisis. These are important reforms.
The administration also takes some steps in making more rational the mix of financial regulatory agencies and how responsibilities are assigned among them. But bowing to likely resistance on Capitol Hill, the administration backed away from a more dramatic attempt at consolidation of these agencies. There is something to be said for having multiple regulators—the more eyes on an industry the less likely they all are to miss something.
Yet as the administration notes in its justification for consolidating power in the Fed, spreading out responsibility reduces the accountability of individual regulators and makes the catching of systemic problems less likely. While the political challenges of developing a more coherent set of institutions with sensibly aligned responsibilities are great, and taking nothing away from the progress represented in what the administration proposes—it’s a disappointment that at this once-in-generation re-evaluation we can’t engage in truly comprehensive reform.
One elephant in the room—that the administration, for good reason, addresses somewhat sketchily—is the need for international cooperation in regulation. Finance is now global, as was driven home in no uncertain terms during the recent financial collapse. Each country needs to get its own house in order—but for any nation to succeed will require all to have a measure of success.
No system can be made regulator proof. As Congress takes the baton, however, it should keep in mind that it isn’t enough to create a structure where good regulators face minimal obstacles to doing their jobs well and where market incentives are well calibrated. These are important, but the system also needs to be one that limits the damage that bad regulators can cause both by creating mechanisms that are not dependent on those regulators and by making information publicly available so that the first time we know there’s a problem isn’t when it’s too late.
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Vice President, Economic Policy