What Is To Be Done on Financial Regulation?
At a hearing of the House Financial Services Committee on July 21, Rep. Barney Frank, chairman of the House Financial Services committee, nicely summarized where we are with regard to re-regulation of our largest financial institutions: some of them are definitely "too big to fail," with the potential to present the authorities with what Larry Summers calls the "collapse or bailout" choice, but what exactly should be done about it?
On a five-person panel, I had the middle seat (as usual) and found myself agreeing with points made both to my left and to my right. Alice Rivlin, former vice chair of the Fed and former OMB director, is correct that we need to control leverage as well as increase capital requirements, and the Fed's tools vis-à-vis leverage need modernization—your grandparents' margin requirements would not suffice. Peter Wallison, a member of the new financial crisis investigation commission, and a former Treasury and White House official under President Reagan, stresses that capital requirements should be higher for larger banks. Paul Mahoney, dean of the U.Va. law school, wants to change the bankruptcy code, to make it easier for courts to handle large financial firms in quick time; recent CIT Group events suggest this is a good idea.
And Mark Zandi was persuasive on the point that households had no idea what they were signing up to with option adjustable rate mortgages [ARMs]—even he has trouble with those spreadsheets. Effective consumer protection—including a new consumer safety commission—would definitely contribute to financial system stability.
What will Barney Frank and his committee do? There will be no "Tier 1 Holding Company" category of firms, if Frank has anything to do with it; this is too much like creating an implicit government guarantee. Frank is clearly drawn towards higher capital requirements or more insurance payments from firms that pose more system risk. I suggested total assets of 1% of GDP as a threshold, but we agree this should be essentially a progressive drag on profits—creating the strong market-based incentive for the biggest firms to downsize.
Other than that, watch this space.
My written testimony submitted to the committee is below.
1. The US economic system has evolved relatively effective ways of handling the insolvency of nonfinancial firms (through bankruptcy) and small or medium-sized financial institutions with retail deposits (through a FDIC-run intervention process). These kinds of corporate failures inflict limited costs on the real economy, and even a string of problems in such firms does not generally jeopardize the entire financial system.
2. We do not yet have a similarly effective way to deal with the insolvency of large financial institutions (e.g., any bank with assets over $500bn, which is roughly 3 percent of GDP). When one of these firms gets into trouble, the authorities face an unpalatable choice of "bailout or collapse." If the problems spread to more than one firm, the balance of responsible official thinking shifts towards: "bailout, at any cost".
3. The collapse of a single large bank, insurance company, or other financial intermediary can have serious negative consequences for the US economy. Even worse, it can trigger further bank failures both within the United States and in other countries—and failures elsewhere in the world can quickly create further problems that impact our financial system and those of our major trading partners.
4. As a result, we currently face a high degree of systemic risk, both within the United States and across the global financial system. This risk is high in historical terms for the US, higher than experienced in most countries previously, and probably unprecedented in its global dimensions.
5. Short-term measures taken by the US government since fall 2008 (and particularly under the Obama administration) have helped stabilized financial markets—primarily by providing unprecedented levels of direct and indirect support to large banks. But these same measures have not removed the longer-run causes of systemic instability. In fact, as a result of supporting leading institutions on terms that are generous to top bank executives (few have been fired or faced other adverse consequences), systemic risk has likely been exacerbated.
6. Some of our largest financial firms have actually become bigger relative to the system and stronger politically as a result of the crisis. Executives of the surviving large firms have every reason to believe they are "too big to fail." They have no incentive to help bring system risk down to acceptable levels.
7. Specifically, the surviving large US financial firms and their foreign competitors have a strong incentive to resume "pay-for-performance" incentive systems—they compete by attracting "talent," and if any one firm brings its compensation under control, it will lose skilled employees. But these firms—and their regulators—have also demonstrated they cannot prevent such incentives from becoming "pay-for-disguised-risk-taking" on a massive scale.
8. The potential for unacceptable systemic risk remains deeply engrained in the culture and organizational structure of Big Finance. Over the past 30 years, this sector has benefited from a process of "cultural capture," through which regulators, politicians, and independent analysts became convinced this sector had great and stabilizing technical expertise. This belief system is increasingly disputed, but still remains substantially in place—big banks are, amazingly, still presumed by officials to have the expertise necessary to manage their own risks, to prevent system failure, and to guide public policy.
9. There are four potential ways to reduce system risk going forward
- Change our regulations so as to reduce ex ante risk-taking, e.g., by more effectively controlling the extent of leverage in the financial system or by more tightly regulating derivatives transactions.
- Change the allocation of regulatory authority within the financial system, so that the relative powers of the Federal Reserve, Treasury, FDIC and various other regulators are adjusted.
- Make it easier for the authorities to close down failing large financial companies using a revised "resolution authority."
- Change the size structure of the financial system, so that there are no financial institutions that are "too big to fail."
10. All of these approaches have some appeal and it makes sense to proceed on a broad front—because it is hard to know what will gain more traction in practice.
11. The growing complexity of global financial markets means that even sophisticated financial sector executives do not necessarily understand the full nature of the risks they are taking on.
12. There is no ideal—or even proven—regulatory structure that will work inside the US political system. Relative to the alternatives, strengthening the FDIC makes sense. For certain levels of potential bailout (e.g., as with CIT Group recently), the FDIC has an effective veto power over providing some forms of government support. This has proved a helpful check on the discretion of the Federal Reserve and the Treasury recently, but it would be a mistake to assume this will be the case indefinitely.
13. While an extended "resolution authority" could be helpful, it is not a panacea. As markets evolve, new forms of interconnections evolve—and we have learned that not even managers of the best run banks understand how that affects the transmission of shocks. Furthermore, as banks become more global, an effective resolution authority would need to span all major countries in comprehensive detail. We are many years away from such an arrangement.
14. The stakes are very high—the country's fiscal position has been significantly worsened by the current crisis, and our debt/GDP ratio is on track to roughly double.
15. As a result, it makes sense also to consider measures that will reduce the size of the largest financial institutions. The recent experience of CIT Group suggests that a total asset size under $100bn may provide a rough threshold, at least on an interim basis, below which the government can allow bankruptcy and/or renegotiation with private creditors to proceed.
16. Market-based pressure for size reduction can come through a variety of measures, including higher payments to the FDIC (or equivalent government insurance agency) from institutions that pose greater system risk, higher capital requirements for bigger firms, and differential caps on compensation based on the cost of implied government assistance in the event of a failure—think of this as pre-payment for failure.
17. Breaking up our largest banks is entirely plausible in economic terms. This action would affect less than a dozen entities, could be spread out over a number of years, and would likely increase (rather than reduce) the availability of low-cost financial intermediation services.
18. The political battle to set in place such anti-size measures would be epic. But as in previous financial reform episodes in the United States (e.g., under Teddy Roosevelt at the start of the 20th century or under FDR during the 1930s), over a 3-5 year period even the most powerful financial interests can be brought under control.
19. If we are able to make our largest financial firms smaller, there will still be potential concerns about connected failures or domino effects. Much tougher implementation of "safety and soundness" regulation is the only way to deal with this. In that context, stronger consumer protection—through a new agency focused on the safety of financial products—would definitely help (as well as being a good thing for its own sake).
The remainder of this testimony (see this pdf) provides further background regarding how systemic risk developed to its current high levels in the US, and suggests why we need new limits on financial institutions whose management regards them as "too big to fail".
Also posted on Simon Johnson's blog,
Baseline Scenario. Following were previously posted by Simon Johnson.
Jamie Dimon v. Larry Summers (July 19)
Jamie Dimon has won big. JP Morgan Chase now stands alone, both in financial position and political clout—including special access to the White House and, as explained in today's NYT, Rahm Emanuel's likely attendance at his next board meeting tomorrow. [The Emanuel visit was cancelled after the meeting was reported in the NYT.]
Dimon's semiotics have been brilliant throughout the crisis—it wasn't his fault, he was forced to take TARP money, and—in phrasing that will make the history books—bankers should not be "vilified". But now he has a problem.
Larry Summers forcefully stated Friday that high recent profit levels for big banks (i.e., JPMorgan and Goldman) are based on the support they received and still receive from the government (listen to his answer to the second question, from about the 6:10 to 10:30 mark). At that level of generality, in a period of financial stabilization and consequent reduction in executive branch discretion, this statement does not threaten Dimon or anyone else.
And Summers' statement on the dangers of "too big to fail" was "too vague to succeed". Dimon saw this one coming and is very much aligned with Tim Geithner on the technocratic fixes that will supposedly take care of this—the mythical "resolution authority", which will not actually achieve anything because it has no cross-border component, so the next time a major multinational bank (e.g., JP Morgan) fails, the choice again will be "collapse or bailout" (as Summers put it in the same Q&A Friday). Yes, I know the G20 is supposedly working on this; no, I don't think they are making progress.
But Summers also drew a line in the sand on consumer protection.
Reformists within the administration really need a new consumer protection agency for financial products—there is little else they will be able to point to as an achievement on banking issues. Summers did not, for example, on Friday even mention the need for stronger regulation over derivatives; Dimon has likely already prevailed on this.
Consumer protection is easy for people to understand. If the banking lobby really defeats or defangs it this year—as it almost certainly can—won't that make meaningful re-regulation of banking a big issue for the midterm elections in 2010 and beyond?
And does Dimon really want to publicly confront and defeat Larry Summers?
It must be tempting for Dimon to now press home his advantage, including at the White House. But as JP Morgan Chase stands alone at the top of our banking hierarchy, how far should he push his luck?
Summers has an unparalleled ability to move the consensus. And if he is now running from the left to become chair of the Fed—which was my impression on Friday—this will shift all candidates, including Ben Bernanke, towards being tougher on banks.
Why doesn't Dimon instead seize on greater consumer protection as a way to rebuld legitimacy for finance—and to shape the new rules so as to create barriers to entry and growth for future rivals?
What would John Pierpont Morgan have done?
Who Nationalized Whom (July 17)
Hank Paulson's testimony yesterday was informative, if only because it illustrated that he himself still understands little about the origins and nature of the global crisis over which he presided. Perhaps his book, out this fall, will redeem his reputation.
A fundamental principle in any emerging market crisis is that not all of the oligarchs can be saved. There is an adding up constraint—the state cannot access enough resources to bail out all the big players.
The people who control the state can decide who is out of business and who stays in, but this is never an overnight decision written on a single piece of paper. Instead, there is a process—and a struggle by competing oligarchs—to influence, persuade, or in some way push the "policymakers" towards the view:
- My private firm must be saved, for the good of the country.
- It must remain private, otherwise this will prevent an economic recovery.
- I should be allowed to acquire other assets, opportunities, or simply market share, as a way to speed recovery for the nation.
Who won this argument in the US and on what basis? And have the winners perhaps done a bit too well—thinking just about their own political futures?
On who must be saved, we see the new dividing line. If you have more than $500bn in total assets, post-Lehman, you make the first cut. If you're below $100bn (e.g., CIT), you can go bankrupt.
On remaining private, the outcome is more complicated. Citigroup had the best political connections in the business, but turned out to be so poorly managed that the state essentially had to take over—in a complicated and ultimately unsatisfactory way. Bank of America's relatively weak political connections meant that the impulse purchase of Merrill Lynch could go very badly—and also led to a bizarre form of government takeover.
The prevailing idea and organizing principle for this new sorting is not Lloyd Blankfein's "we're the catalyst of risk"—investment banks are peripheral, rather than central, to nonfinancial risk taking and investment in this country. It's Jamie Dimon's idea: just don't demonize the competent bankers, let us take things over and we'll smooth it all out.
The problem with this approach is its "success", from the point of view of the remaining bankers—their market share is up so sharply that it's embarassing. Of course, they can still argue that banking is a global industry with many competitors (some of which are even bigger, with more state assistance, promising much craziness in the years ahead).
But the real issue now is concentration in the political marketplace. Hank Paulson dealt with a dozen big banks/similar institutions with deep connections to Capitol Hill and a very powerful small banking lobby. Tim Geithner is looking at just a couple of big banks that are still independent . Probably we should start to divide our big banks into the "nationalized" and the "nationalizers".
The small banks still have clout—and you'll see them in force on the regulatory reforms debate this fall—but they know now that they don't get bailouts, and access to contigent state capital-on-amazing-terms is the ironic basis of modern financial power.
We are looking at a concentration of political power in the US banking system that we haven't seen since the 1830s: Shades of Andrew Jackson vs. the Second Bank of the United States. We put up with a lot from our banking elite in this country, but historically we draw the line at financial power so concentrated it can confront the power of the President.
The logic for reform and for breaking up the big banks begins to build. Bank of America's fall was, in some senses, a fortunate accident for Goldman and JP Morgan. But it has also given them an excessive and unsustainable degree of political power.
Of course, you also have to ask: Who can break that power, when, and how?