Too Big to Fail Politically
What is the essence of the problem with our financial system—what brought us into deep crisis, what scared us most in September/October of last year, and what was the toughest problem in the early days of the Obama administration?
The issue was definitely not that banks and nonbanks could fail in general. We're good at handling some kinds of financial failure. The problem was: A relatively small number of troubled banks were so large that their failure could imperil both our financial system and the world economy. And, at least in the view of Treasury, these banks were so large that they couldn't be taken over in a normal FDIC-type receivership. (The notion that the government lacked legal authority to act is smokescreen; please tell me which statute authorized the removal of Rick Waggoner from GM.)
But instead of defining this core problem, explaining its origins, emphasizing the dangers, and addressing it directly, what do we get in the 101 pages of regulatory reform proposals released on June 17?
- A passive voice throughout the explanation of what happened (e.g., this preamble). No one did anything wrong and banks, in particular, are absolved from all responsibility for what has transpired.
- A Financial Services Oversight Council, which sounds like a recipe for interagency feuding, with the Treasury as the referee and, most important, provider of the staff. The bureaucratic principle is: If you hold the pen, you have the power.
- Some of the largest banks ("Tier 1 Financial Holding Companies", or Tier 1 FHCs) will now be subject to supervision by the Federal Reserve Board, although under the confusing jurisdiction also of the Financial Services Oversight Council in many regards (e.g., in the key setting of material prudential standards), and subsidiaries can have other regulators.
- Tier 1 FHC should have higher prudential standards (capital, liquidity, and risk management), but "given the important role of Tier 1 FHCs in the financial system and the economy, setting their prudential standards too high could constrain long-term financial and economic development." Sounds like a banker drafted that sentence. None of the important details/numbers are specified, although the Fed should use "severe stress scenarios" to assess capital adequacy. Is that the same kind of actually-quite-mild stress scenario they used earlier this year?
- In terms of risk management, "Tier 1 FHCs must be able to identify aggregate exposures quickly on a firm-wide basis." There is no notion here that risk management at these big banks has failed completely and repeatedly over the past two years. How exactly will FHCs be able to identify such risks and how will the Fed (or anyone else) assess such identification?
- In case you weren't sufficiently confused by the overlapping regulatory authorities in this plan, we'll also get a National Bank Supervisor (NBS) within Treasury. Regulatory arbitrage is not gone, just relabeled (slightly).
- There is no greater transparency or public accountability in the regulatory process. We still will not know exactly what regulators decided and on what basis. Such secrecy, at this stage in our financial history, clearly prevents proper governance of our supervisory system.
- There appears to be no mention that corporate governance within these large banks failed totally. How on earth can you expect these banks to operate in a responsible manner unless and until you address the reckless manner in which they (a) compensate themselves, (b) destroy shareholder value, and (c) treat boards of directors as toothless wonders? The profound silence on this point from the administration—including some of our finest economic, financial, and legal thinkers—is breathtaking.
There's of course more in these proposals, which I review elsewhere and Secretary Geithner's appearances on Capitol Hill may be informative, although only if his definition of the underlying "too big to fail" issue uses much stronger language than yesterday's written proposals.
But based on what we see so far, there is little reason to be encouraged. The reform process appears to have been captured at an early stage—by design the lobbyists were let into the executive branch's working, so we don't even get to have a transparent debate or to hear specious arguments about why we really need big banks.
Writing in the New York Times, Joe Nocera sums up, "If Mr. Obama hopes to create a regulatory environment that stands for another six decades, he is going to have to do what Roosevelt did once upon a time. He is going to have make some bankers mad."
Good point, but Nocera is thinking about the wrong Roosevelt (FDR). In order to get to the point where you can reform like FDR, you first have to break the political power of the big banks, and that requires substantially reducing their economic power. The moment calls more for Teddy Roosevelt–type trustbusting, and it appears that is exactly what we will not get.
Also posted on June 18 on Simon Johnson's blog, Baseline Scenario.
Previous postings by Simon Johnson
Three Views on Regulatory Reform for Finance (June 17)
There are three views on who exactly is behind the financial regulatory reform package that will be officially presented June 17. Each view has distinct implications for the political dynamics going forward.
The first view is that Tim Geithner and Larry Summers have genuinely become radical reformers. They see the error of the ways they pursued during the 1990s, both in terms of financial deregulation for the United States and in their advice to other countries, particularly through the capital market liberalization policies urged upon the IMF. They now seek to put globalized finance back in its box and will pursue any sensible means possible to this end.
This view is not widely held.
The second view is the consensus: Geithner and Summers want a minimal degree of reform with a great deal of window dressing. This interpretation is supported by the fact that most of the specifics with regard to large financial firms look like moderate technocratic tweaks, i.e., hardly what you'd expect in the aftermath of what the president himself called, "the worst financial crisis since the Great Depression."
It's true, and always pleasing to officials, that you can get a nice media bump with background briefings on all the effort that has gone into the proposals. But honestly, what in the administration's proposals is strong enough to have prevented this crisis, let alone preempt the next crisis, which, by all indications, could be even larger now that big financial players know for sure they are too big to fail?
The administration could have taken over Citigroup—e.g., placing it into negotiated conservatorship—at several points in the last nine months. It did not. Draw your own conclusions and think for a moment about how this will influence future actions in the financial sector.
The third view is more interesting and also controversial: Geithner-Summers have exercised an effective veto over measures that would have constrained large firms directly, but they are not at this time strong enough to prevent sensible consumer protection measures from also going forward.
In this view, someone (Cass Sunstein?) and his/her allies have managed, at least so far, to promote the idea of a consumer protection agency focused on financial products. The details are not yet clear enough to see how what will emerge, and we also don't yet know how vigorously Treasury will defend this idea against the financial-sector lobbies. But at least this is something new and potentially powerful in all the right ways.
Sunstein, of course, is known for the idea of a Nudge: pushing consumers ever so gently toward better decisions. It's a fine principle to guide thinking, but lobbies, opponents within the administration, and members of Congress with their own agenda will not be moved through gentle means.
This is going to be quite a fight.
A Viewer's Guide to President Obama's Announcement (June 16)
At 12:30 pm on June 17 at the White House, President Obama is due to "unveil" his proposals for reforming the functioning of our financial system. The content has already been foreshadowed in some detail, most notably by the Geithner-Summers op-ed in the Washington Post on Monday, but what the president himself stresses is still important. Everyone who matters for the reform of financial regulation will be in attendance and his remarks (and perhaps those of Secretary Geithner) can absolutely set the tone of the debate.
In particular, the implicit story the president tells will frame our collective discussions going forward and, on some points, could even help tip the balance against established lobbies.
There are at least 10 important questions the president may address or shy away from tomorrow.
- Does President Obama buy the idea that what happened to our financial system was a "rare accident," or does he think that something more systematic has gone wrong?
- Does he think that the crisis itself will take care of many problems, for example by chastening the remaining bankers to behave well indefinitely or somehow making their organizations less stupid? Or does the crisis serve just as a wake-up call to all of us: Unless and until we fix the system, we will be vulnerable to further damaging crises?
- Does the president realize and stress sufficiently the damage that has been done by bankers, for example as seen in the increase in our national debt that arises directly from their malfeasance, from around 40 percent of GDP to 70 percent (administration estimate) or 75 percent (IMF yesterday) or above 80 percent (my view). He needs to say clearly: This cannot happen again—we simply can't afford another financial calamity on this scale.
- Does he state plainly and unequivocally that the way the financial system has been run, and continues to be run, has damaged the national interest of the United States and pushed millions of people, both here and around the world, closer to poverty?
- Most important, does the president stress the need to protect consumers from the financial industry going forward, specifically with a strong Financial Products Safety Commission. Messrs. Geithner and Summers seem, at best, lukewarm to this idea. In fact, we have no clear indication that they buy into the idea of consumer protection at all. The president's position on this issue will be decisive.
- If a bank or other financial institution is "too big to fail," how exactly does the president's plan to deal with it in the future? Even if a wind-down can be managed by Treasury, with its new resolution authority (if granted), what will be the expected cost to the taxpayer? If "too big to fail" is not, in the president's view, "too big to exist," kindly explain why not.
- Can the president bring himself to state in public the obvious: The extent of political influence in the hands of our financial system—large banks in particular, but small banks also in some instances—is out of control and dangerous? Where is the administration's reform agenda on this crucial point? To those of us who frequent Capitol Hill, it looks very much like business as usual, albeit with higher political market share for the big banks that remain in business.
- Has the president really been briefed on the supposed benefits of having large financial institutions with great economic power and pervasive political influence? Don't just claim that these are a good thing; tell us, in detail, and preferably with numbers, what we the public gain from the presence of these behemoths among us. Keep in mind that "everyone has them" is no kind of argument—something so manifestly dangerous is not to be blindly copied.
- Why was executive and other compensation so notably absent from the latest Geithner-Summers joint statement of our problems and likely solutions? Does the president really expect us to believe that any set of reforms will work if they do not directly constrain the amounts that can be earned from misunderstanding risk today and hoping that the consequences do not appear on your watch? Does he have any idea of how the people who run big financial firms will game whatever controls that try to limit their risk-taking?
- Can President Obama finally talk about the much broader break-down of corporate governance in this country, with boards of directors serving no discernible purpose in terms of limiting the excesses of corporate executives in the financial sector but also more broadly? Surely, without a reform package that includes measures to address this core issue, we will get exactly nowhere.