Financial reform at last – is it enough?

Former Federal Reserve Chairman Paul Volcker, Chair of the President's Economic Recovery Advisor Board, and author of the Volcker Rule

Last night, just before the clock turned to midnight, almost two years after the global financial system nearly collapsed, House and Senate committees reached agreement on reconciliation of their respective Financial Reform packages.  The bill should be headed for a successful vote.  What level of protection will we have going forward?

Looking back, the economy nearly collapsed because of too much systemic risk spread across financial institutions that are “too big to fail.”  At the 11th hour, after Bear Sterns nearly collapsed, and Lehman Brothers went into bankruptcy, the surviving financial institutions converted into bank holding companies and received access to the Discount Window at the Federal Reserve, which allowed them to reduce their leverage with basically free money.  In addition to that bailout, much of the toxic assets on the books of these institutions were bought or guaranteed by the Fed.

Would it be enough to require these institutions to hold more capital?  Simon Johnson points out that the targeted requirement of 10-12% is actually what Lehman Brothers had on the book before they collapsed.

One good aspect of this bill is the inclusion of a compromise Volcker Rule.  Paul Volcker, the former Federal Reserve Chairman who proposed the rule, intended to restrict the ability of banks whose deposits are federally insured from trading for their own benefit. Banks and large Wall Street firms, who view it as a major incursion on their most profitable activity, fiercely oppose the Volcker Rule.  The compromise would allow them to continue some investing and trading activity, no more than 3 percent of a fund’s capital; those investments could also total no more than 3 percent of a bank’s tangible equity.

The proposal by Senator Blanche Lincoln that would have banned banks from any derivatives activities was loosed to a requirement that banks and the companies that own them be required to segregate the activity.  In theory this would prevent depositors money from being traded in derivatives, but isn’t this just shuffling around the balance sheet instead?

The new Consumer Protection Agency is a good move.  If the President puts someone like Elizabeth Warren in charge, we will see standardized, consumer friendly credit card statements, along with many other sensible reforms.  Of course, an exception for Auto Dealers was negotiated at the last minute.  If you go outside any military base you will she signs that say “financing available for E-1 and above.”  What those signs don’t say is that the interest rates for those E-1’s will be 30%, and that those 18-year-old kids just want the shiny new car.  In the same vein, I hope payday lenders will be subject to the new Agency, though I don’t doubt that powerful legislators may have exempted them as well.

Ultimately, at the end of the day, while there are admirable measures in this Reform, and while it is better than the status quo, this bill does nothing to deal with institutions being too big to fail.  The Brown Kaufmann amendment, which was defeated by among other opponents, The White House, would have forced banks to become smaller and limited what they could borrow from the Fed.  We taxpayers will one day have to confront these massive institutions and bail them out again, with the proverbial gun to our head.  It is inevitable.

It is instructive to look at the history of Bear Sterns, as detailed in the excellent book, House of Cards.  When that firm became a stalwart after the Great Depression, the partners were all personally invested in each financial investment decision.  They had skin in the game, and they were much more conservative as a result.  Deregulation in the 1980s and the 1990s allowed firms like Bear Sterns to leverage, more and more, their clients funds, and engage in riskier and riskier behavior.  Without the personal investment, the people in charge of Bear Sterns were no longer worried about the long view, just the next quarter.  Much like politicians who are simply worried about re-election and not about proper governance, these denizens of Wall St. were now only concerned with rising stock price and short term gains.  We lost something along the way, and unfortunately, we are not going to get it back.

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Complexity and Volitility

It is sometimes difficult to keep up with all of the complex technological changes going on in our society.  Take Facebook, for example.

If you haven’t seen this illuminating diagram, which illustrates the changes to Facebook Privacy between 2005-2010, you might not fully grasp how easily your personal information may leak onto the world-wide web.  Facebook is constantly looking for ways to monetize the assets that they have, namely, your personal information.  Recently Facebook made another huge change, implementing a platform that they call Connections.  Here are some helpful warnings about Connections.  You may want to check your privacy settings, at a minimum.

James Kwak, co-author of 13 Bankers, as well as the blog Baseline Scenario, decided to delete all of his personal information from the site.  If you are unsure about how much gets onto the world wide web, just check out this site.

However, this phenomenon is not limited to Facebook.  Last week, the U.S. Stock market plumeted 700 points in a matter of minutes.  It partially rebounded, but at the end of the day, the heads of NASDAQ and NYSE were trading blame, and it appears that the smart people designing the complex electronic trading mechanisms do not fully understand them.

When told that 50-75% of all stock trades are High Frequency, automated trades, that transact by the miliseconds, Duncan Niederauer, CEO of NYSE said “everyone has to compete on technology, we’re all going to ask ourselves is how fast is too fast, when is enough enough.  But, as long as there is technologically-enabled market making out there, everyone has got to compete for that market share.”

Felix Salmon, financial blogger for Reuters, calls this a new era of volitility:

“The lesson to learn is that given the complexity of contemporary financial markets, correlations can pop up anywhere, and a relatively small uptick in something like Portugese CDS spreads can combine with a glitch somewhere in the equity markets to get magnified into an event which wipes out hundreds of billions of dollars in capitalization in the blink of an eye. Or maybe it was the UK election, or a butterfly flapping its wings in Kuala Lumpur: there’s no way of ever knowing.”

The complexity inherent in the stock markets is eerily reminiscent of the complex financial products which led to the collapse of our economy.  Some of the Collateralized Debt Obligations and Derivatives were poorly understood by the people in charge at firms like Bear Sterns.  As a result, they did not comprehend the risk those products held to our country.  For a good blow-by-blow account of how the people in charge at Bear Sterns were unable to grasp the complexity of those products, check out William Cohen’s House of Cards.

While Facebook and High-Frequency Trading are not obviously related, they both amount to systems that are inherently complex.  Our society will only become more and more automated, we cannot just accept that complexity, we must remain aware and vigilant.

UPDATE (5/28): This great column from David Brooks discusses how complexity and our inability to understand it played a huge role in the Oil Spill.