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.