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"Disappointing and Inspiring": Roosevelt Fellows and Colleagues React to FinReg

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I asked Roosevelt Institute fellows and New Deal 2.0 colleagues to explain the good, the bad, and the ugly on the FinReg bill.

Robert Johnson, Roosevelt Institute Senior Fellow and Director of the Project on Global Finance; Executive Director, INET:

The financial reform legislation is both disappointing and inspiring. The legislation is the product of a broken government process where dollars overwhelm voters. Lobbying in the gazillions predictably stopped the needed major structural reforms that were revealed by the scope and scale of the financial crisis. As a result we still have "too big to fail" firms with the perverse incentive (subsidy) that their default-free status confers upon them. We still have many practices that are not transparent and many off balance sheet problems that disguise the conditions of our financial firms. We are also still a society that tolerates usurious interest rates on credit cards and payday loans. That is deplorable.

What is heartening is to see how so many people and organizations -- who had little knowledge of this arcane subject matter two years ago -- have contributed the energy to learn and engage and push relentlessly for reforms against the monied odds. Notions such as consumer financial protection, the Lincoln attempts to separate OTC derivatives from the protective umbrella of the balance sheet of taxpayer protected banks, (and she did it in response to a primary challenge, please do not lose site of that fact), and efforts to remove risky activities from the guaranteed funding protections are a tribute to this energy.

It is also heartening to see people like Michael Greenberger, Elizabeth Warren, Damon Silvers, Dennis Kelleher, Matt Stoller, Jane Hamsher, the AFR team, Bob Kuttner and Senators Cantwell, Dorgan, Levin, Kaufman and Merkeley leading this formidable effort.

This is the first act of a many act play. Finance was too large in proportion to our economy. It is still too large, and our dysfunctional political system that aided and abetted the growth of the financial sector over the last 20 years cannot be expected to turn on a dime and enact profound and needed change. That agenda is still ahead. This first round was not the whole fight. It was the wake-up call and the beginning of the fight. Rest up and get ready. There is so much more to do.

Elizabeth Warren, TARP Watchdog and New Deal 2.0 contributor:

It has been more than 20 months since the largest financial crisis since the Great Depression, and we are still living under the same set of rules we had in place before the meltdown. Thanks to the leadership of President Obama, Chairman Frank, and Chairman Dodd, that's about to change. Members of the House-Senate conference committee and their staffs worked through the night to produce the strongest set of Wall Street reforms in three generations. They created a strong, independent consumer agency that will have the tools to rein in industry tricks and traps and to cut out the fine print. For the first time, there will be a financial regulator in Washington watching out for families instead of banks.
Marshall Auerback, Senior Fellow at the Roosevelt Institute; Market Analyst, RAB Capital:

The whole approach to financial reform has failed to deal with the core problems with gave rise to the crisis in the first place. Credit default swaps, collaterised debt obligations, etc., need to be understood as key components of an integrated system, the so-called "shadow banking system", which was at the epicenter of the crisis. More broadly speaking, the shadow banking system needs to be understood as a key component of the larger capital market-based credit system that has, in the last three decades, risen to supply the majority of our credit, largely replacing the traditional bank-based credit system.

Recognizing that this is our new structure presents an important starting point for reforming it. As Jan Kregel has noted, this evolving structure has illustrated how liquidity creation has been increasingly transferred from deposit creation by commercial banks subject to prudential regulation, to securitized structures that have been increasingly exempt from reporting and regulation because they are considered "capital market activities". They have also been generally exempt from even SEC oversight -- each one of these structures could be considered a ghost or "shadow" bank. Thus, as Kregel argues, "the liquidity crises in 1998 and 2008 produced, not a run on banks, but a collapse of security values and insolvency in the securitized structures, and the withdrawal of short-term funding from the shadow banks. The safety net created to respond to a run on bank deposits was totally inadequate to respond to a capital market liquidity crisis."

The new "financial reform" bill merely reflects the model of a banking structure which was already largely gone by the time we abolished Glass-Steagall. The proposed bill fails to recognise that in a capital market-based credit system, the key player is not the bank that originates and holds the loan, but rather the dealer who makes liquid markets in the security into which the loan is bundled. In such a system, the focus of regulation should not be on the capitalization and liquidity of banks per se, but rather on the capitalization and liquidity of dealers. As Professor Perry Mehrling has noted in testimony to the French National Assembly last week, "just as in 1913, when the Federal Reserve System was created to regularize and bring under public control the operations of the bankers' club that until then had been serving as a private lender of last resort, so today the historic task is to regularize and bring under public control the operations of the dealers' club that has been serving as private dealer of last resort."

The failure of AIG clearly demonstrates that a private sector entity cannot be the party to sell the "insurance" on CDOs. If the concern is to make completely sure of the seller's ability to cover the loss of a bond at par on demand, treating the default event as a random event that can occur without warning at any time, then collateral would have to be equal to the par value of the referenced bond. Putting credit default swaps on exchanges might facilitate transparency, but it does not deal with the underlying LIQUIDITY issue raised here because every private sector entity is balance sheet constrained in a way that the government is not. In fact, it might simply create a centralised point of failure on the exchange.

Ideally, systemically risk products such as credit default swaps should be abolished, as they serve no public purpose. But this is impossible in the real world. Pandora's Box has been opened and can't be shut again.

The problem with today's reform is that sellers of credit default swaps without an adequate capital cushion may be required to post collateral on an exchange, which raises the question, "How much collateral is enough?" AIG clearly didn't have enough. Potentially, no private financial institution does.

By contrast, the Federal Reserve can always provide the requisite liquidity to make good the payment. In standing as "dealer of last resort" (much as it already serves the function of lender of last resort under a traditional banking system), the Fed would be in a better position to monitor the balance sheets of the dealer and take earlier corrective action should those balance sheets reflect signs of incipient financial instability, as well as charging the right "premium" to insure such products.

We should also impose greater regulatory oversight on the products emerging from this capital based market system. There is no reason why the SEC could not rescind rule 3a-7, which has exempted securitised structures from registration and regulation under the Investment Companies Act. This rescission would functionally act like a Tobin tax insofar as the resulting higher regulatory thresholds would likely slow down the proliferation of new securitised products, as well as imposing a great fiduciary responsibility on the issuer. The beauty is that this change could come from the SEC itself, and not require an act of Congress (thereby enabling us to avoid this horrible charade to which we have been witness over the past several months on financial reform).

As far as updating the so-called "Volcker Rule", let us recognize that the Constitution reserves the provision of currency to the government. Consequently, there is no reason for the major part of this obligation to be outsourced to the private sector. We should have a national giro system or, at the very least, a protected and closely regulated portion of the financial sector for those who do not want to take excessive risks. And any institution that bets with "house money" -- that is, that has access to the Fed in the case of a liquidity problem and to the Treasury in the case of insolvency, must be constrained if they operate under this system. This would deal with the systemic issues implied by "too big to fail" as it is not size per se which is the problem, but the implied guarantees for activities which contribute to overall financial instability that creates the problem. The Japanese Post Office Bank is a far less systemically risky institution than Goldman Sachs, for example.

Of course, none of these proposals are included in the bill about to be signed into law by the President, which is why I fully expect a recurrence of today's crisis in a relatively short period of time. It's probably one of the few times I find myself in agreement with the predictions of Jamie Dimon. But it would be nice to prevent the next one from recurring within his 5-7 year time frame.

Arjun Jayadev, Fellow at the Roosevelt Institute; Assistant Professor of Economics, UMass, Boston:

The late Nobel Laureate James Tobin, in a famous lecture from 1984, spoke about what he termed the 'functional efficiency' of the financial system. As he put it, "The...concept relates.. to the economic functions of the financial industries... These include: the pooling of risks and their allocation to those most able and willing to bear them... the facilitation of transactions by providing mechanisms and networks of payments; the mobilization of saving for investments in physical and human capital... and the allocation of saving to their more socially productive uses."

In the aftermath of a global crisis of enormous proportions, lawmakers have had an opportunity to think about this foundational concern and to repurpose the financial system to improve its efficiency. By any reasonable measure, finance is too big, both as a proportion of the economy and in the sense that there are a few companies that are too large for efficiency and equity. In addition, the sector has an undue influence on the politics and values of society. This is corrosive to society and what offends and damages the population. The current approach to financial reform unfortunately has not adequately attended to this concern. Certainly, some things are to be celebrated: the CFPA and the stronger than imagined derivatives bill are among these. But there is nothing to suggest that the financial sector will function fundamentally differently than before. Maybe there will be less potential for such a severe crisis, though there are many untested provisions and a lack of clarity on key issues (for example, money market backstopping in the event of a run). But in other ways, the form and content of the financial sector has only been weakened at the edges.

William K. Black, Roosevelt Institute Braintruster and New Deal 2.0 contributor; Associate Professor of Economics and Law, University of Missouri - Kansas City:

The fundamental problem with the financial reform bill is that it would not have prevented the current crisis and it will not prevent future crises because it does not address the reason the world is suffering recurrent, intensifying crises. A witches' brew of deregulation, desupervision, regulatory black holes and perverse executive and professional compensation has created an intensely criminogenic environment that produces epidemics of accounting control fraud that hyper-inflate financial bubbles and cause economic crises. The bill continues unlawful, unprincipled, and dangerous policy of allowing systemically dangerous institutions (SDIs) to play by special rules even when they are insolvent. Indeed, the bill makes a variety of accounting control fraud lawful. The financial industry, with Bernanke's support, already got Congress to extort FASB to gimmick the accounting rules so that insolvent banks could hide their losses and continue to pay the executives (already made rich by destroying "their" firms -- that's the meaning of Akerlof & Romer's classic article: "Looting: Bankruptcy for Profit") massive bonuses. All of this is made possible by huge, off budget subsidies to the SDIs via the Fed and Fannie and Freddie.

The idea that consumer protection should rest on the Fed's tender mercies is a particularly sick joke. The Fed, institutionally, has never made "safety and soundness" regulation more than a tertiary concern. The Fed's historic approach to consumer protection regulation is malign neglect.

Cross-posted from New Deal 2.0.