The Good, the Bad, the Ugly: Financial Sector Regulation

There are major gaps and shortcomings in the Obama administration's financial regulatory proposals, formally released today, and the proposals alone leave the financial sector vulnerable to future crisis. Still, it's nice to be able to say that the proposal does contain meaningful reforms.

Whether those meaningful reform proposals become law is no sure thing, and will depend on the administration's willingness to stare down Wall Street -- which still retains immense political power, despite its partial self-immolation -- and on whether a mobilized public demands Congress act for consumers, not contributors.

The 85-page draft released today is qualitatively different than the bullet-point plans previously issued by the Treasury Department. It contains detailed proposals, spanning across the financial regulatory spectrum, not easily summarized. Here are only some key elements -- first, the good, then the bad.

The Good

1. The administration supports creation of a strong Consumer Financial Regulatory Agency.

It proposes to give this new agency very strong powers, and jurisdiction over consumer protection rules -- taking away authority from existing regulators (like the Federal Reserve) that have failed utterly to protect consumers. It favors simplicity and gives the new agency the authority to mandate financial firms offer "plain vanilla" loans along with the more complicated packages they prefer. It gives the agency authority to ban mandatory arbitration provisions that strip consumers' right to go to court for redress of scams and rip-offs. And it establishes that the new agency's rules will be a regulatory floor, with states permitted to adopt stronger protections.

2. The administration proposes to reduce speculative betting, through new standards on leverage.

One reason the financial crisis spun out of control was financial firms' excessive use of "leverage" -- borrowed money. Heavily leveraged, the top commercial banks and investment banks overreached with very risky loans and investments. The administration proposes that all systemically important financial firms be subjected to higher capital reserve standards (meaning they can rely less on borrowed money). The administration properly says these rules should apply to any systemically important firm, whether or not it is a bank. It defines systemically important as a firm "whose combination of size, leverage and interconnectedness could pose a threat to financial stability if it failed." There are still important details to be worked out here, including how much capital such firms must maintain. And there is the very worrisome element that it is the Federal Reserve that is given primary responsibility for overseeing these systemically important firms.

3. Through "skin-in-the-game" rules, the administration aims to prevent predatory and reckless lending.

One reason lenders were willing to make so many predatory and bad-quality mortgages -- including but not limited to the class of "subprime" loans -- was that mortgage originators did not hold on to the loans. Mortgage brokers cut deals on behalf of banks and non-bank originators, which in turn sold the resulting mortgages to other banks. These banks, in turn, sliced and diced the mortgages, combined them into packages of pieces of thousands of other mortgages, and sold them to all kinds of investors. Because the initial lender did not maintain an ongoing interest in the mortgage, they did not have any incentive to ensure they were making a quality loan.

The administration proposes that loan originators be required to keep, at minimum, a 5 percent exposure in loans.

4. The administration seeks power to take over failing, systemically important financial firms.

The government already has such "resolution" power for commercial banks. The Federal Deposit Insurance Corporation regularly takes control over failing banks and "resolves" them outside of the bankruptcy process. This typically means selling off the failing bank to another bank, often after separating its good assets from bad. FDIC is expert at this process, moves very quickly, and averts the harmful consequences from extended bankruptcy processes.

The government does not have the legal authority to undertake comparable measures for important non-bank firms. This includes investment banks (think Lehman Brothers) and insurance companies (think AIG). Giving the government resolution power for non-banks should help control financial panic.

The Bad

1. The administration does not propose to do anything serious about executive pay and top-level compensation for financial firms.

The administration does support "say-on-pay" proposals, which give shareholders the right to a *non-binding* vote on executive compensation. But a non-binding vote isn't worth too much; and, more importantly, shareholders are often willing to support excessive compensation while risky bets are paying off.

In terms of financial stability, the imperative is to do away with the Wall Street bonus culture, where executives and traders are given extraordinary bonuses -- often four or more times base salary -- based on annual performance. This bonus culture gives traders and executives alike an incentive to take big bets -- because they get massive payoff if things go well, and don't suffer if they go bad, or go bad sometime in the future.

This is a structural problem, not a symbolic one. Anyone who thinks pay isn't of overriding importance in financial regulation should have been set straight by the desperation of the bailed out Wall Street firms to pay back their loans from the government. That desperation is overwhelmingly tied to a desire to escape the extremely modest pay standards issued by the Obama administration.

Besides financial stability, there are important questions of economic justice and taxpayer rights related to executive compensation. The Wall Street hotshots -- including the major hedge fund players -- have paid themselves unfathomable amounts of money over the last decade. They have set an aspirational standard for other executives and professionals, and helped drive wealth and income inequality to outrageous and unhealthy levels. Ultra compensation should be taxed at very high rates; and, at a bare minimum, the loopholes that let hedge fund managers pay taxes at about half the rate of regular folks must be closed. The case for aggressive tax reform on ultra rich financiers was overwhelming last year; now, with the financial system completely dependent on taxpayer largesse, there shouldn't be anything left to debate. No one in finance can say they made their money just by working hard or being clever -- their system was saved by the government.

2. The administration does not propose structural reform of the financial sector.

Although it proposes some meaningful regulatory reform, and modest alteration of the structure of regulatory agencies, the administration does not propose to alter the structure of the financial sector itself.

There is no discussion of returning to Glass-Steagall principles, to separate commercial banking from other financial activities including the speculative world of investment banking. Glass-Steagall was adopted during the Great Depression, as a response to financial abuses that closely parallel those of the previous decade. Repeal of Glass Steagall -- following a decades-long erosion -- came in 1999, and helped pave the way for the present crisis.

Nor is there any discussion of shrinking the size of goliath financial firms. Everyone now recognizes the problem of too-big-to-fail and too-interconnected-to-fail financial firms. The administration proposes to deal with the problem through regulation alone; a more fundamental approach would break up giant firms (or at least commit to prevent further consolidation going forward).

Addressing structure and size is important not only because of the economic power accreted by the goliaths, but because of their political strength -- about which, see below.

3. The administration's approach to regulating financial derivatives is too timid.

To its credit, the administration proposes to repeal recent deregulatory statutes and establish regulation of financial derivatives. But its plan does not go far enough. It creates a regulatory exemption for customized derivatives -- a loophole that will create lots of business for corporate lawyers ready to change terms in derivative contracts so that they differ somewhat from standardized terms.

Nor does the administration propose to ban classes of dangerous financial instruments that cannot be justified. A clear example of a product that should be banned is a credit default swap -- a kind of insurance against a certain outcome, like the inability of a bondholder to make required payments -- in which neither party has a stake in the underlying transaction. Such credit default swaps have no insurance component, and are nothing more than bets -- but they are bets that can vastly exceed the value of the transaction being bet on, and can spread financial contagion, as AIG demonstrated. George Soros argues that all credit default swaps basically share this feature, and should be banned altogether.

The administration proposal also fails to require that exotic financial instruments be subjected to pre-approval requirements. Under such an approach, financial firms would be required to show that new instruments offer some social benefit, and do not pose excessive risk.

4. The administration does not propose to empower consumers.

There is enormous merit to the proposal for a Consumer Financial Products Agency. But it is not a substitute for giving consumers the power to organize themselves to advance their own interests. Simply mandating that financial firms include in bills and statements (whether mailed or e-mailed) an invitation to join an independent consumer organization would facilitate tens of thousands of consumers -- and likely many more -- banding together to make sure the regulators do their job, and to prevent Wall Street from "innovating" the next trick to scam borrowers and investors.

The Ugly

Identifying the merits and gaps in the administration's proposal is important. But the proposal does not exist in a vacuum, and it doesn't become law just because the administration has proposed it.

The Wall Street types don't know shame. Having benefited from literally trillions of dollars of taxpayer largesse, one might expect that they would be embarrassed to lobby on Capitol Hill. Or, that Members of Congress would be unsympathetic to their pleas.

But that's not how Washington works. Having spent $5 billion on political investments over the last decade, Wall Street continues to pour cash into the political process -- and those investments continue to pay handsomely.

To understand how things work, consider the fate of the proposal to give bankruptcy judges the power to adjust mortgages, so that they could reduce the principal owed on loans on homes now worth less than value of the loan. Then-candidate Barack Obama campaigned in favor of such "cram-down" provisions. In a rational world, banks would agree to these adjustments to principal on their own, because they do better if people stay in their homes and continue paying on the loan, rather than by forcing foreclosure. Not long ago, it was widely expected that cram-down would quickly become law. But the banks deployed their lobbyists, and this vital though totally inadequate measure was defeated in May. The Obama administration sat quietly by.

Now, Wall Street is already trashing the good parts of the administration's proposals.

"Congress is not going to impose a 'skin-in-the-game' requirement on all loans," Jaret Seiberg, an analyst with Washington Research Group, a division of Concept Capital, flatly tells American Banker.

The Chamber of Commerce and other industry groupings are attacking the idea of a Consumer Financial Product Agency, including with the extraordinary claim that it will improperly relieve consumers of their duty to do "due diligence" on financial products.

Hedge funds are hiring ever more lobbyists and floating the claim that the administration's requirements for some modest disclosure requirements for secretive hedge funds could do more damage than good. One purported reason: the disclosures may be too complicated for regular people to understand.

There's no question that Wall Street is going to mobilize -- is already mobilized -- to defeat the administration's positive proposals.

What remains very much in question is the administration's willingness to engage in bare-knuckled political fighting to defend these proposals, as well as whether the public will be mobilized to support these and other moves to control Wall Street.

A new public interest coalition -- Americans for Financial Reform -- aims to do just that, but they are fighting on occupied territory. As Senator Majority Whip Richard Durbin says, "the banks are still the most powerful lobby on Capitol Hill. And they frankly own the place."

(Disclosure: My organization, Essential Action, is a member of Americans for Financial Reform.)

Comments

[AnonymousBanker]

Regulators: Our Nation's Ball-less Wonders! The Fed is on the top of the list!
http://anonymousbanker.com/?p=234

In light of Obama's new Financial Regulatory Reform Plan, I feel the need to reiterate my comments on our financial industry's regulators, which I refer to as our Nation's Ball-less Wonders. In this article I explain how our laws are converted to regulations and the responsibility of our regulators to protect our country by actually enforcing these regulations.

The debate should not be over whether the Fed should become the mega-regulator, but rather whether the Fed has, in the past, performed its job to protect this country and our economy by actually enforcing the regulations that exist.

When we evaluate the benefits of a mega-regulator, I would say that any consolidation that reduces expenses and thereby saves taxpayer dollars, is a good plan. That being said, the Fed has failed us miserably in the past and I have no reason to believe that they will perform any better in the future.

My fear is that transferring this authority to one agency only dilutes the systems of checks and balances and reduces the possibility that some agency, any agency, will cry foul and take action when the financial companies fail to follow our laws. Perhaps the plan might work, if, in addition to the consolidation, the people were also represented by an ombudsman to act as watchdog when the Fed fails to do its job, as it surely will.

[Jim P]

No financial system reform is complete without forcing the markets to operate 24/7. An always open market can not have gap-ups or gap-downs. The cause for these price movements in unclear to me. It seems that the small number of shares that are pending transactions before the markets open have an extraordinary weighting on the market averages. It could just as easily represent a market maker adjusting the opening price to sell 'house' shares at profit or inflating the bid to ask markup for no justifiable reason other than he can do it.

In addition, all market related transactions should go through the markets, that is end 'private placement'. The standard justification for private placement is that large stock movement could mistakenly undermine a stocks value. For example a large share holder could be selling the stocks to finance a critical family need which is not a reflection of his perceived change in market value. Although this seems plausible, at most it would cause a spike in the stock's price. This 'benefit' should be weighed against strong reasons against the practice. It allows high worth individuals to acquire stock below market price. It keeps information away from the market that undermines the 'self correcting' nature of free markets that is taught in economics.

The thrust of these two suggestions is to improve the flow of information or enhance the transparency of the market for the good of the market and its participants.

[TJCole]

The Banks and Wall St. want self non-regulation regulation...

Of course only Swindlers are Against Regulation...!

So this shows nothing has changed since the crash in September 2008 and nothing will change until there is a major change in the banking culture, and we get rid of the swindlers..!

[whit3hawk]

Obama’s lukewarm reaction and total lack of decisively ruthless action to handle what in effect is criminal behavior comparable to grand larceny is not surprising.
Regulations of the financial market and the behavior of the financial community are more important and would have done a lot more to rein back the financial collapse that TARP (Troubled Assets Relief Program), or the ARRA, stimulus package law. The regulations as contained in the proposal are good, but if history is to be any indication, Obama will take what he can get, and lay down.
The financial community is supposed to manage people’s portfolios. As such, they can only be entitled to bonuses in proportion to gain in customer’s portfolios, i.e.: real productivity. The financial community has lost billions and more of the general populations’ portfolios. That's grand larceny.
The public hasn’t a clue on basics economics 101, and how to understand the bigger picture with that fundamental knowledge. A superficial understanding of it, would tell one that while the financial markets sore, and the real production stagnates of fall and unemployment continues to rise, the financial markets are trading worthless paper, no matter what the numbers say they are. Remember, eventually, all that paper will be used to buy good and services, and if the real economy isn’t producing them, it will all have been for naught. And that’s exactly what had been happening at least since 1986 when I started watching and researched previous activity.

[bnr2]

Page 29 to 30 of the administration plan describe its proposals to reform executive compensation at financial firms. It may not go as far as we would like, but it is in there. Moreover, the plan both acknowledges the role that executive compensation practices played in triggering the crisis and calls on regulators to issue rules and guidelines to better align executive compensation practices with long-term shareholder interests and financial stability. We still need Congress to add a more robust section to the plan on corporate governance and executive compensation more generally, but this plan definitely offers more than an empty say-on-pay proposal.

[kbee819]

Excellent article. I agree with your assessment of the "good", the "bad" and the "ugly". It's absolutely the current structural paradigm (Goliath) that prevents the needed structural changes mentioned. Although the reforms are more than window dressing to placate the masses, more could be done to ensure the fiduciary duty is strengthened between investors, consumers and the financial sector. That being said, it is sound principle to require the "originator" to retain an interest in securitized transactions. It is sound principle that all financial institutions be required to hold larger reserves and gamble less on borrowed money. Simply put, shopping with my money versus someone else's money changes my whole perspective of a "good deal". It is sound principle that regulators will have authority to step into life blood financial institutions with preventive measures to avert a large scale crisis. The question is whether authority will be proactive or simply to administer CPR at the 11th hour. Another problem you point out are the tax loopholes that look like a chinese checkerboard. With such "financial creativity" on Wall Street any reform which even appears to limit excessive profit and bonus structures by execs, will be recovered by creative tax strategies. Although a non-binding shareholder vote on exec. compensation is just that, non-binding, why not? It would certainly send a strong message from one partner to the other. I hope the President takes the same approach with opponents that he took with Chrysler hold-outs, shame them into submission.

[drymartini1]

i have an easier solution.

NO home loans without 20% down. The 20% downpayment cannot be covered by a second loan. It must be in cash and must be provided by the buyer of the property.

problem solved!!

[mbaty]

I'm surprised no one has commented yet. The fascinating thing about all of this is that these large financial institutions with rich lobbyists are furthering the destruction of the economy as a whole with their stubborn behavior. Obviously they want to make as much money as they can as fast as they can during this crisis of opportunity, but by not respecting those that utilize their services they will create their own ending. Our economy should ideally be about more than just money. Money cannot be a sufficient determinant in all of our choices. It is crucial that we think about the environment, that we consider natural disasters as being a fact of life, and that we set up the safety nets we will need in moments of crisis. Capitolism has it's benefits, but when money trumps all else, even the very habitability of the planet, we're headed for a change--either for the better or for the worse. Either the financial sector reforms or it will totally eventually collapse, as it would have already had the government not stepped in. Even a house of cards needs a solid base. We are that base.