Volcker, Warren, and Kaufman: There Must Be New Law
Some people at the top of the administration begin to understand that it makes both economic and political sense to impose binding constraints on our largest banks. But even the clearest thinking among them still has a problem—breaking up banks seems too much at odds with the way they saved these same banks in 2009. At best, this would be most awkward for the individuals involved on all sides.
"We'll achieve the same general goal by imposing capital requirements that increase with the size of the bank" (not an exact quote) is the administration's latest whispered idea, and in principle this has some appeal. If done properly, this could level the playing field—and therefore should be supported politically by small banks. By increasing the buffer against future losses, it would put in place greater protection for taxpayers against too big to fail (TBTF) institutions. And it would push TBTF firms to break up if they really have nothing better than cheap funding—based on implicit government subsidies—to support their continued existence.
But this "let's do it with capital requirements" proposal is deeply flawed and completely unacceptable. From different perspectives, Paul Volcker, Elizabeth Warren, and Ted Kaufman all agree that we cannot rely on our existing regulations (and regulators). We need new law.
Setting capital requirements involves a delegated decision, i.e., Congress indicates some parameters in general terms that the executive branch has to implement. The broad authority is in the hands of top people at the White House/Treasury, while the mind-numbing details fall to the regulators (subject to political pressure). So how do you write the capital requirements legislation that has the "end TBTF" outcome?
The bottom line is that you would have to trust the White House and myriad regulators. But neither have credibility on this front, as Senator Ted Kaufman insists. Given their track record, they might promise to raise capital enough, but once the moment of political attention is over, they'll likely just roll over for the big banks again.
Accommodating the interests of big firms—if that is what you want to do—is made all the more easy by the complexity of the issues involved. What is the level of capital requirements for the largest banks that would really level the playing field? Would 20 percent get it done? Why not 30 percent—which is more like the average of pre-1913 capital-asset ratios, i.e., before the era of modern bailouts? No one knows—and a good deal of assertive experimentation would be required.
On top of this, the international part of capital requirements runs through the Basel Committee, which (1) takes a long time; (2) is highly technical; and (3) is murky without any real accountability—i.e., by the time someone writes a front page Wall Street Journal article on what went wrong, it's 5 years too late. A key function of international organizations, not subject to disclosure like US public institutions or discovery like US private organizations (facing lawsuits), is to hide all kinds of dubious actions—there is by definition no sunlight. You can shred all the documents you want at an international organization; no one on the outside will ever get you for this.
Any approach that puts heavy emphasis on capital requirements comes down to trusting the Obama administration's economic team to be suitably resilient in the face of heavy pressure from big banks. But when these same people had the choice of being tough or nice to big failed bankers, by their own admission they went overboard on the niceness—no one on the board of directors of Citigroup was even embarrassed by what happened in early 2009. This tells us something about preferences, style, and how our top officials see the world—whether you want to call this nonconfrontational, highly deferential to the financial sector, or awe of Jamie Dimon.
How can any reasonable person trust the administration to get capital requirements right—i.e., so as to force TBTF banks to make themselves smaller—particularly when the Europeans have serious fiscal-financial problems, will want to paper over their own capital deficiencies, and are much more comfortable using implicit government guarantees to back banks than the United States is (or should be)?
There is no substitute for new law here—just as Elizabeth Warren argues (and we discuss further in 13 Bankers). And the only law that will really deal with massive banks is law that effectively constrains their size—the point that Paul Volcker has been making and will likely reiterate Tuesday.
The Case for Optimism
March 28, 2010
On Friday afternoon, NPR's All Things Considered broadcast Robert Siegel's interview with me on 13 Bankers (further down that link there is an excerpt from the very beginning of the book).
We talked, naturally enough, about how the ideas in 13 Bankers connect with the current policy debate—specifically the financial reform legislation now before the Senate. As anticipated when the book went to press in January, some sensible measures to protect consumers of financial products seem possible—yet this progress just emphasizes how and why we have not yet broken through on too big to fail issues.
But there is a broader point here also. What happened in 2008–09 should not be allowed to happen again. The nature of power in and around the financial sector has become so great—and so distorted—that it harms the rest of us.
I don't think a majority of Americans understand how much influence financial institutions have in Washington, DC. Banks used to answer to Washington. They were once held accountable for their actions. That is no longer is the case.
We have not previously had such a concentrated banking system in the United States; it's terrifying how much of our financial future is wrapped up in the big six. We don't need this level of concentration and we should recognize the dangers that it brings. This view is not anti-finance—but we are very much against the way our biggest banks operate today, and we definitely (and in detail) oppose people who seek in any way to sustain the power of these organizations.
The NPR interview hit many key points but also—in 8 minutes—just scratched the surface. In 13 Bankers, we take you through the back story—the painful history that brought us here and that now makes it so hard to move forward.
But the book is not pessimistic. We offer American models of reform—instances from our history when elected representatives, with all their limitations and failings, took on concentrated financial power. Luckily for us, despite its massive and seemingly overwhelming advantages, big finance lost in each of the three big confrontations of the past two hundred years.
Each time, most Americans initially did not grasp how the system works, and this proved a major obstacle to reform. But each time political leadership was able to explain what needed to be done—and to persuade the mainstream that this was an important priority.
We can do it again. We must—the consequences otherwise would be too awful. Absent reform, another bailout—indeed a more costly bailout with global consequences, millions of jobs lost, and a ruinous impact on our government budget—is unavoidable.
Who Will Tell the President? Paul Volcker
March 28, 2010
Against all the odds, a glimmer of hope for real financial reform begins to shine through. It's not that anything definite has happened—in fact most of the recent Senate details are not encouraging—but rather that the broader political calculus has shifted in the right direction.
Instead of seeing the big banks as inviolable, top people in the Obama administration are beginning to see the advantage of taking them on—at least on the issue of consumer protection. Even Tim Geithner derided the banks recently as "those who told us all they were the masters of noble financial innovation and sophisticated risk management."
In part this is window dressing. But in part it recognizes political opportunity—the big banks are unpopular because they remain completely unreformed and unrepentant. And in part it responds to a very real danger—Senator Dodd's bill is so obviously weak on "too big to fail" issues that it will be hard to paint its opponents as friends of big banks.
Senator Richard Shelby knows this and is taking the offensive. The administration can convert an easy win into its own goal if it fails to toughen substantially Senator Dodd's bill.
Fortunately, there is an easy way to address this issue.
Recall the political history of financial reform during the Obama administration. The economic team (Tim Geithner and Larry Summers) felt that no substantive change in the structure and incentives for deeply troubled parts of the financial system was necessary or even possible during the height of crisis. Consequently, they provided unlimited financial support to the country's largest banks—communicated by the "stress tests"—with no conditions, and they also proposed an initial set of legislative changes that was slight.
Quite quickly, however, this strategy ran into trouble—because the largest banks immediately and demonstrably went back to their uncontrolled risk-taking ways, now based on obvious government guarantees. The lack of careful management within these banks is not an accident—it's very much part of the design, which enables large bonuses to be paid at all levels; the point is not that individuals intentionally engender crisis every year, but the system runs through a loop that implies regular (and, in our view, increasing) government support over time. Too big to fail pays well; for the banks it is someone else's problem to fix, and for policymakers the temptation is to kick all available cans down the road.
From summer 2009, leading banks also exuded arrogance—insulting the president and generally carrying on in a high and mighty fashion. The abuse of power by our ever more powerful bankers became increasingly obvious—as did their lobbying (Neal Wolin, deputy Treasury secretary, said this week that "big banks and Wall Street financial firms" spend $1.4 million per day on "lobbying and campaign contributions" and "there are four financial lobbyists for every member of Congress." Good speech.).
With perfect timing during the fall, in stepped Paul Volcker. Not someone ever accused of being a populist—let alone carrying a pitchfork—he pointed out, simply and forcefully (and publicly), that our biggest banks were out of control and must be reined in. With the political side of the White House increasingly anxious about the electoral effects of pandering to an apparent financial oligarchy, Volcker was able to persuade the president to adopt the Volcker Rules: a limit on the risk taking by big banks and an effective cap on their size.
Unfortunately, the specifics of the Volcker Rules were not well thought through by Treasury and their cause was hardly championed with force. The Capitol Hill lobbying machine took over and mush duly appeared from Senator Dodd's committee on the issue of systemic risk.
But Paul Volcker is not finished, not by a long way. Someone just needs to convince President Obama to call Senator Dodd (or meet again with Dodd and Barney Frank) to ask—politely but firmly—that the Volcker size cap on big banks be legislated, and actually tightened relative to the January proposal. The House already has the Kanjorski amendment, which is a step in the right direction.
On Tuesday Volcker will go public again. But that's not the most important conversation. His public appearance is just a way to communicate more directly with the political side of the White House.
Volcker's point is simple. Without the Volcker Rules, the administration would be in much more difficulty than it is now; these proposals really helped to diffuse pressure. Now it's time to make the Rules real—and this requires significantly reducing the size of our largest banks. Phase the rules in, as proposed in January, and there is no reason to think this will constrain our recovery.
Chris Dodd can start this ball rolling and Barney Frank would back him up. The consensus is ready to move. This is such an easy and obvious political win. Treasury and the White House economic team can be brought onside by being allowed to claim this was their idea all along—or they can say something along the lines of "the facts changed, so we changed our opinions."
But if Paul Volcker doesn't tell the president, who will?
Hard Pressed, Senator Dodd Gives Ground
March 27, 2010
Senator Chris Dodd has good political antennae. He knows that his financial reform bill will come under severe pressure because it has a weak heart—the provisions that deal with "too big to fail" are simply "too weak to make any sense."
Stung by the hard-hitting critique of Senator Ted Kaufman earlier on Friday and unsure exactly where an increasingly combative White House is heading on the broader strategy vis-à-vis banks, Mr. Dodd took to the Senate floor yesterday afternoon—actually immediately after Senator Kaufman—in an attempt to sustain the momentum behind his approach to "reform."
Note the prominent and rather defensive mention of Delaware, Senator Kaufman's state, in what Senator Dodd said (the wording here is from the verbatim recording, not the official transcript):
"A business, as I say respectfully, in Connecticut or Delaware or Colorado, a homeowner in those states shouldn't have to pay the price because a handful of financial institutions got too greedy, too risky, they were unwilling to examine what they were doing or did, recognizing that the federal government would bail them out if they made a bad choice, which they did."
Senator Dodd asserts that "never again should a financial problem of a major financial institution put the rest of the country at risk." But there is no mention of the specific reforms that would prevent this.
Mr. Dodd does express exactly the right general idea,
"First and foremost, never, ever again should a financial institution get so large, so interconnected, produce products that put the rest of us at risk."
But the cognitive dissonance here is extreme. The only purported mechanism to rein in megabanks in the Dodd bill is the resolution authority but this, by definition, cannot work for large complex cross-border financial institutions—this is the point insisted upon by Senator Kaufman today.
Dodd recognizes the validity of Kaufman's argument at some level, but just cannot bring himself to say that he agrees—or to acknowledge that his legislation does nothing to deal with financial institutions that have already proved themselves to be so large they can damage society.
So we reach an impasse—at least for now. Dodd concedes that too big to fail is the central issue and he implicitly acknowledges that his bill has no way to address the concerns raised by Senator Kaufman (and Paul Volcker and others).
The White House has cleared the way for major progress versus the financial sector lobby (nice speech by Neal Wolin to the Chamber of Commerce), but does not yet press home its advantage.
Barney Frank knows there is a deep flaw in the current legislation and waits in the wings with a sharp pencil. He previously thought "too big to fail" firms could be taxed down to size; increasingly this seems unrealistic and at odds with the shifting consensus on systemic risk.
Chris Dodd wants to go out in blaze of glory, not with a bill that makes no sense at all on its most critical points.
Ted Kaufman is turning into a relentless critic, Elizabeth Warren is fast becoming a folk hero, and Paul Volcker is poised to make a major speech in Washington on Tuesday. Is Volcker likely to toe the party line and defer to Senator Dodd—or will he lay out in forceful terms what reforms would really mean, i.e., what are the true Volcker principles, who has them, and how would you know?
Financial reform might make for good television after all.
Senator: Which Part Of "Too Big To Fail" Do You Not Understand?
March 26, 2010
When a company wants to fend off a hostile takeover, its board may seek to put in place so-called "poison pill" defenses—i.e., measures that will make the firm less desirable if purchased, but which ideally will not encumber its operations if it stays independent.
Large complex cross-border financial institutions run with exactly such a structure in place, but it has the effect of making it very expensive for the government to takeover or shut down such firms, i.e., to push them into any form of bankruptcy.
To understand this more clearly you can
The Citigroup situation is simple. They would like to downsize slightly, and are under some pressure to do so. It is hard to sell assets at a decent price in this environment, so why don't they just spin off companies—e.g., quickly create five companies in which each original shareholder gets a commensurate stake?
The answer is that Citi's debt is generally cross-guaranteed across various parts of the company. US and foreign creditors have a claim on the whole thing, more or less (including the international parts), and you can't break it apart without upsetting them. The cross-border dimensions make everything that much more knotty.
Senator Kaufman explains what this means—essentially the "resolution authority" proposed in the Dodd legislation is meaningless. How would any administration put a huge bank into any kind of "resolution" (an FDIC-type bank closure, scaled up to big banks) when it knows that doing so would trigger default across all the complex pieces of this multinational empire?
You could do it if you are willing to accept the costs—and if you understand there are big drawbacks to providing an unconditional bailout of the 2009 variety. But will a future administration be willing to take that decision? The Obama administration was not—and big finance will only become bigger and more complex as we move forward.
If you look into the eyes of the decision makers from spring 2009, they honestly believe that taking over Citi or Bank of America would have caused greater financial trouble and a worse recession. You can argue about their true motivation all you want; this is irrelevant. The point is that the structures in place last year remain unchanged today. If a megabank shut down under pressure was impossible for our policymakers last year, how exactly will the situation change after the Dodd bill passes—remembering that our current policymakers or a close facsimile will run this country for the indefinite future?
Senator Kaufman is strong too on what this all means. By all accounts, this senator is not a person who came to the boom-bust-bailout debate with strong preconceived notions, just someone who has listened carefully to the arguments on all sides. And, unlike most politicians, this Senator does not need to raise money.
Banks that are "too big to fail" are simply too big. Making them smaller may not be sufficient to prevent major crises in the future—Senator Kaufman sensibly also supports a long list of related reforms, including for derivatives markets (see his other speeches on this topic: first, second)—but rolling back our biggest and most dangerous banks certainly is necessary. And there is simply no evidence that banks on today's modern scale convey any benefits to society.
Massive banks cannot be controlled, at least not in the US context; we are not Canada. "Smart regulation" in this context is an oxymoron. Our regulators have been captured by the ideology of finance for 20 years; the big banks industry is not about to let them out on parole now.
For a long while, the Obama administration insisted that size caps for banks were not on the table. Then, in January, the president himself announced the Volcker Rules—which include a size cap for banks. We've argued this cap should be even tighter—big banks can get smaller in an orderly fashion and regulators can help—but still any cap would be a step in the right direction.
Yet there is no size cap in Senator Dodd's bill.
Given that this White House has shown it can achieve considerable things, when it applies itself, why not pursue the Volcker Rules in full?
The White House is clearly not afraid of the business lobby—Deputy Secretary Neal Wolin took on the Chamber of Commerce this week regarding the Consumer Protection Agency for Financial Products; his tone was strong and his arguments were telling.
Yet the White House, Senator Dodd, and perhaps even Barney Frank are all stuck on one issue—they can't contemplate making our biggest banks smaller (or even limiting their size).
It's as if a very clever political poisoned pill has been put into place. If you act against the big banks they will—what exactly? Threaten to prolong the recession? Help your opponents get elected? Run ads against everything you believe in?
Whatever the reason, write it down and think about it. How do you feel about a small set of big financial firms having this kind of power? How is that good for the rest of the business community, let alone regular citizens and our democracy?
This administration is perfectly capable of taking on the big banks. All that is missing is a little clarity of thought and a fair amount of political courage. Or they can just call up Senator Kaufman.
Financial Reform: Will We Even Have a Debate?
March 25, 2010
The New York Times reports that financial reform is the next top priority for Democrats. Barney Frank, fresh from meeting with the president, sends a promising signal:
"There are going to be death panels enacted by the Congress this year—but they're death panels for large financial institutions that can't make it," he said. "We're going to put them to death and we're not going to do very much for their heirs. We will do the minimum that's needed to keep this from spiraling into a broader problem."
But there is another, much less positive interpretation regarding what is now developing in the Senate. The indications are that some version of the Dodd bill will be presented to Democrats and Republicans alike as a fait accompli—this is what we are going to do, so are you with us or against us in the final recorded vote? And, whatever you do—they say to the Democrats—don't rock the boat with any strengthening amendments.
Chris Dodd, master of the parliamentary maneuver, and the White House seem to have in mind curtailing debate and moving directly to decision. Republicans, such as Judd Gregg and Bob Corker, may be getting on board with exactly this.
Prominent Democratic Senators have indicated they would like something different. But it's not clear whether and how Senators Cantwell, Merkley, Levin, Brown, Feingold, Kaufman, and perhaps others will stop the Dodd juggernaut (or is it a handcart?).
This matters because there is more than a small problem with the Dodd-White House strategy: The bill makes no sense.
Of course, officials are lining up to solemnly confirm that "too big to fail" will be history once the Dodd bill passes.
But this is simply incorrect. Focus on this: How can any approach based on a US resolution authority end the issues around large complex cross-border financial institutions? It cannot.
The resolution authority, you recall, is the ability of the government to apply a form of FDIC-type intervention (or modified bankruptcy procedure) to all financial institutions, rather than just banks with federally insured deposits as is the case today. The notion is fine for purely US entities, but there is no cross-border agreement on resolution process and procedure—and no prospect of the same in sight.
This is not a left-wing view or a right-wing view, although there are people from both ends of the political spectrum who agree on this point (look at the endorsements for 13 Bankers). This is simply the technocratic assessment—ask your favorite lawyer, financial markets expert, finance professor, economist, or anyone else who has worked on these issues and does not have skin in this particular legislative game.
Why exactly do you think big banks, such as JPMorgan Chase and Goldman Sachs, have been so outspoken in support of a "resolution authority"? They know it would allow them to continue not just at their current size—but actually to get bigger. Nothing could be better for them than this kind of regulatory smokescreen. This is exactly the kind of game that they have played well over the past 20 years—in fact, it's from the same playbook that brought them great power and us great danger in the run-up to 2008.
When a major bank fails, in the years after the Dodd bill passes, we will face the exact same potential chaos as after the collapse of Lehman. And we know what our policy elite will do in such a situation—because Messrs. Paulson, Geithner, Bernanke, and Summers swear up and down there was no alternative, and people like them will always be in power. If you must choose between collapse and rescue, US policymakers will choose rescue every time—and probably they feel compelled again to concede most generous terms "to limit the ultimate cost to the taxpayer" (or words to that effect).
The banks know all this and will act accordingly. You do the math.
Once you understand that the resolution authority is an illusion, you begin to understand that the Dodd legislation would achieve nothing on the systemic risk and too big to fail front.
On reflection, perhaps this is exactly why the sponsors of this bill are afraid to have any kind of open and serious debate. The emperor simply has no clothes.
The Brown Amendment: Do the Volcker Rules Live?
March 24, 2010
The administration may be distancing itself from the Volcker Rules, but the same is not true of all senators. (Why did President Obama go to the trouble of endorsing Mr. Volcker's approach to limiting risk and size in the banking system, if his key implementers—led by Treasury Secretary Tim Geithner—were going to back down so quickly?)
Among a number of sensible amendments under development in the Senate, Senator Sherrod Brown (D-OH) proposes the following language (update: text now attached [pdf]):
"LIMIT ON LIABILITIES FOR BANK HOLDING COMPANIES AND FINANCIAL COMPANIES.—No bank holding company may possess non-deposit liabilities exceeding 3 percent of the annual gross domestic product of the United States."
And a few paragraphs later, an essential point is made clear: this includes derivatives,
"OFF–BALANCE-SHEET LIABILITIES.—The computation of the limit established under subsection (a) shall take into account off–balance sheet liabilities."
And there is a strong provision for requiring prompt corrective action if any bank exceeds this hard size cap.
Naturally, the Federal Reserve is pushing back.
The Fed's argument is that any kind of size limitation would be too blunt an instrument—successful regulation requires nuance and subtlety.
Perhaps, but there's a big problem with relying on subtle regulators. Over the past 30 years, almost all our regulators and supervisors have become either sleepy or captured—in a cognitive sense—by the very people they are supposed to be watching over. (Chapters 3 and 4 in 13 Bankers document this in detail; more on that when the book comes out next Tuesday.)
The question of the day can be framed as the classic, "Who will guard the guardians?" Or you can just ask, loudly, "Where the heck were the people charged with the safety and soundness of the system over the past decade?"
It would be sheer folly to rely on "smart regulation" going forward—yet Larry Summers and Tim Geithner seem to be taking that approach. Just answer this, preferably in public: What happens when another president with the philosophy of a Reagan or a Bush starts to make appointments?
The Brown amendment is not perfect—in 13 Bankers we recommend a blanket size cap, rather than treating deposit and nondeposit liabilities separately. But this amendment would definitely be a step in the right direction.
Our regulators have failed us repeatedly. What we need now is some smart legislation.