Running down the list of provisions in the same order as Mark Thoma
Consumer Protection Agency. I’ve very skeptical of this. Regulators tend to do simple things well and complicated things poorly. This is a complicated mandate. Professional investors screwed up massively in the late 2000s, buying all kinds of products they didn’t understand. Heck, the same firms who designed the products were also buying them. One reason they got into trouble was that they off-loaded the responsibility of assessing risk to the ratings agencies, who independently “blessed” a lot of these investment products with high ratings. One unintended effect of the existence of this agency will be to reduce consumer caution about any financial product “blessed” by the agency. The biggest fraudulent practices of the late-2000s related to credit were practices where all parties were complicit in the fraud. If you tell somebody that they’ll better qualify for a loan if they lie about their income and don’t provide documentation, it’s very implausible to me that the consumer in question didn’t understand that fraud was involved. I suspect that the agency won’t ultimately do much to protect consumers, but will fool at least some people into thinking they are protected.
Derivatives Traded on Exchanges. I’m skeptical that the lack of transparency in the derivatives market – not knowing who owed what to whom – was actually an important component of the crisis. That’s more what happened in 1998. What was important was the lack of a central clearinghouse because that meant that there was no generally agreed upon mechanism for establishing valuations and posting collateral. AIG was insuring huge amounts of risk and posting nothing; then they got downgraded, had to start posting collateral, therefore had to come up with some idea of what their stuff was actually worth, and rapidly entered a death spiral. If derivatives all trade through a central clearing corporation, then everybody has to post collateral and leverage is limited by the clearing corporation. That’s the way the listed options market works and the way the listed futures market works, and it’s how the credit derivatives market should work as well. And, as a side effect, you probably get better price discovery. So this is a good reform.
Resolution Authority. This is a vital reform but people should understand that it has a very limited effect. Basically, this gives regulators the authority to do with a future AIG what they could do with a normal bank. That eliminates a big element of uncertainty going into negotiations between regulators and the company in question during a crisis, and therefore should mitigate the market panic during a crisis. It doesn’t address any questions of fairness associated with bailouts, and it doesn’t really do anything to prevent a crisis from happening, but it should prevent another Lehman Brothers-type total market meltdown when the next crisis occurs. If you look at the difference between how Lehman and Washington Mutual were handled respectively, you can see the vital importance of this reform.
Too Big To Fail. I’m skeptical of this whole frame. General Motors is also too big to fail – we know because the government bailed it out rather than let it fail. It’s not a bank. Any enterprise can grow large enough that, in some geographic scope, it’s too big to fail. My wife hails from Rochester, New York. Kodak, relative to the local economy, is “too big to fail” in that if it failed (and no doubt one day it will) the local economy will collapse. So what is Rochester supposed to do about that? Nobody really has a good answer to that question. From a consumer perspective, local banking monopolies are more problematic than competition among a collection of national behemoths (though the optimal situation for a consumer is both a local franchise that can compete on the basis of local knowledge and a collection of national behemoths who can compete on the basis of greater access to the global capital markets). Nor do I think the size of banks increases their political clout; the most powerful political actors are those with substantial local clout. Notice that the big banks are regulated by the new consumer protection agency but auto dealerships are not. If there is a problem with “embiggering” of banks, it’s that there are perverse financial incentives to get big even when there is no efficiency, because executive compensation is more closely tied to aggregate size than profitability. But if this were a substantial problem then large shareholders should be able to tackle it. I think the real important point of attack is on leverage, not on sheer size. But I will say that politically, anything that forced the big banks to break up into smaller banks would be a big winner, even though it might be counter-productive in policy terms. It’s one regulation that everybody would understand immediately, and that everybody would know big banks were against. Whether it worked or not, it would make the right enemies, from a political perspective.
Volcker Rule Too Weak. Here’s the situation. Hedge funds now have vastly more influence over the financial markets than they ever did in the past, and their compensation structure is such that they inevitably attract the best and the brightest of the financial world. So, to compete, banks have set up in-house hedge funds, either trading for the bank directly or owned and/or guaranteed by the bank. A hard rule prohibiting banks from doing proprietary trading or owning hedge funds would have been a modern version of Glass-Steagall. It would have protected banks from directly engaging in these kinds of risky activities. But it would also have substantially increased the influence of hedge funds on the financial markets from an already high level, because now they would be the only ones able to do certain kind of transactions. And hedge funds are largely unregulated partnerships, so this might actually result in less regulatory oversight. On the other hand, the major way that banks got into trouble in the recent financial crisis was by blurring the line between lending and financial markets activities, the so-called “shadow banking” system. Since this was the most important aspect of the problem in the structure of the banking system, it’s not clear to me that the success or failure of the Volcker Rule is that crucial.
Fed Audits. I agree with Thoma that this is basically politics.
Limits on Leverage. This is the most important part of addressing the financial crisis, and it’s also the toughest. The huge problem here is that banking is a global business, and American regulations need to be consistent internationally to avoid facing a very serious competitive disadvantage. But the way you get international consistency is through the Basel Committee on Banking Supervision which, as you might guess, is several steps removed from democratic accountability. Basel II was responsible for setting the ratings agencies up as arbiters of bank capital, because the amount of capital banks had to hold against AAA-rated assets dropped dramatically (which created a huge incentive for banks to hold AAA-rated assets, which, in turn, since these assets could be created wholesale through structured finance, supercharged the structured finance game). Obviously, Basel III is going to go in a different direction, but the odds of anything like a hard cap on leverage coming out of that process strike me as relatively low. The issues involved in successfully limited bank leverage are very technical, but what I want to highlight is that it is very hard for one major nation alone to tackle the problem, but also difficult for a supranational advisory body like the Basel Committee not to be subject to capture by the industry.
Monitoring Systemic Risk. I have no faith that this can be done effectively. Every risk-management department at every bank is supposed to be thinking about this question all the time with respect to that bank’s financial situation. How’d that work out? The incentives not to rock the boat when the sailing appears good are just as strong at the government level.
Executive Pay. See my comments about hedge funds above. If you successfully limited the pay of bankers, that would only increase the power and influence of unregulated hedge funds. I’m skeptical that executive pay was in any real sense a driver of the financial crisis, except for one sense: that the phenomenal profitability of finance in general caused huge distortions in the disposition of our intellectual assets. That’s not a problem we’re going to be able to tackle with a blunt instrument limiting the pay of CEOs (particularly when individual traders sometimes earn more than those CEOs).
Credit Ratings Agencies. I don’t think the conflict of interest is the fundamental problem. If the agencies were paid by investors rather than by the issuers, the same incentives would apply – investors wanted the agencies to give things they wanted to buy good ratings. The problem is that a credit rating matters too much – that it was used to calculate bank capital, that it was used to justify not having to post collateral, etc. Basically, we need to reduce the market value of a AAA rating, not increase its apparent value by telling the market that now the ratings agencies can really be trusted.
Anyway, that’s my overall take. But the clearinghouse of info – from a left-wing perspective, to be sure, but he’s good about linking to people who disagree with him – is Mike Konczal’s blog.