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Jeff Madrick

Jeff Madrick

Posted: July 13, 2009 01:12 PM

Full Investigation of Crisis is Vital to Democracy


How do we get the facts on how the financial system imploded? Roosevelt Institute Braintruster Jeff Madrick would prefer a special prosecutor -- or at least a special investigator -- to a meaningless bi-partisan hearing.

By now it's clear that there should be a serious philosophical and open debate about how to regulate our financial institutions. Remarkably, we have had none. The Obama administration's deliberations have been behind closed doors, most likely dominated by bankers. It is imperative that the nation have a broader, deeper, more varied, and, if necessary, controversial discussion. The only way to do this is through a Congressional investigation since the Obama administration has called for no public accounting. The public simply does not know what's happened. This is a disgrace to democracy.

To me, the central conflict is judgmental implementation vs. application of specific prohibitions and rule-based requirements. The Obama administration is avoiding a strong advocacy of the latter, and also deferring many decisions about actual rules and requirements to a future date.

In my view , it comes down to this: The Fed, SEC, Comptroller of the Currency, CFTC, FDIC and OTS all had substantial powers leading up to the crisis, but largely did not implement them. Thus judgmental rules and implementation are not enough. Prohibiting activities such as trading for a banking institution's own account or breaking up institutions that are too big and conflicted may be necessary. The right course may be the politically impractical course, which seems to be foremost in the minds of the Obama political team. The bankers will say as they always do that such changes are inefficient. But how much more in inefficiency could such changes produce than we have already had? The Obama adminstration says that they sacrifice the perfect for the good, but in reality they are sacrificing the good for the expedient.

So, here are the key questions about the financial crisis that require answers:

1. Is regulating systemic risk the major reform required? How does it get implemented if it is? Do we establish specific rules or allow the agency in charge to use its judgment on an ad hoc basis? Is there any evidence that such responsibility, without defined structures, has worked in the past? Don't agencies become captured by their industries?

2. Should the Federal Reserve be the principal agency in charge of systemic risk? Because its purview is already large and its staff deep and well-trained, there is reason to think it should. But the Fed has performed poorly, driven, I'd argue, by an ideological chairman. How does one prevent that in the future, especially given that the Fed reports to no one?

3. Should commercial banks or bank holding companies that own them be allowed to trade in securities for their own account? Commercial banks have access to federally insured deposits, which can finance highly risky activities under current rules. This seems a recipe for disaster. Under one roof, we now have deposit-gathering institutions, stock brokerage firms, securitization operations, mortgage brokers, trading operations in everything from stocks and bonds to mortgage-backed securities and other derivatives, and hedge funds. Goldman is a huge hedge fund operator. Bear Stearns financed its failing hedged funds with money from other operations, and then went down the drain. The Fed, the OTS, the Comptroller, and the SEC did not bother to look into these activities even when they had the legal authority to do so. Should there be a plain vanilla sector of the financial industry and a separate risk-taking sector? I think probably so. I'd like to hear the issues aired.

4. Can we control systemic risk through higher and flexible capital requirements? Can we make it too costly to be big through such demands? The Obama administration has offered few details on this.

5. Is there a way to regulate the credit agencies to prevent conflicts of interest? Some say they should be public. A more moderate reform would be to make it so that no government agency, such as Fannie Mae, should base its purchases or securitization on credit ratings by private companies. Basel II capital requirements are based on S&P and Moody's ratings. I think Basel II also relates capital requirements to fluctuations in VAR, thus making official an acceptance of VAR as a measure of risk. This must be analyzed and discussed.

6. Should credit default swaps be allowed at all? Should all be traded on an open exchange? Should capital requirements for such trading be raising significantly, or leverage radically restricted? The Obama advisers have made a large exception for privately negotiated (customized) derivatives in their proposal for a clearing house? Why? CDSs are thought of as insurance. In most areas of insurance-life, accident, health- there is a regulator. None here...

You can read the rest of Roosevelt Institute Braintruster Jeff Madrick's piece at New Deal 2.0.