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Prospects for Financial Reform

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The best opportunity for immediate reform of our financial sector was missed at the start of the Obama administration. As Larry Summers and Tim Geithner know very well -- e.g., from their extensive experience around the world during the 1990s (see Summers's 2000 Ely lecture) -- when a financial system is in deep crisis, you have an opportunity to fix the most egregious problems. Major financial sector players are always good at blocking reform -- except when they are on the ropes. (Look again at Paul Blustein's The Chastening for more detail on what Geithner-Summers, with David Lipton and others, got right when they sided with reformers in Korea.)

Congratulations to the Treasury PR people for placing such a warm and fuzzy article about Secretary Geithner in Vogue (not available on-line, but definitely worth finding; nice photos). But what exactly was the point -- unless Mr. Geithner is planning to run for the Senate in Massachusetts? Mr. Geithner comes through as someone who, against much advice, decided to stick with exactly the financial sector that got us into such deep trouble -- despite the fact that this is exactly what he and his colleagues (at Treasury, at the IMF, and at the NY Fed) have always, and with good reason, strongly urged other countries not to do.

Naturally, the Obama administration's generally weak and unfocused financial reform proposals have morphed into generally weak and unfocused congressional bills. The overall narrative has been lost -- despite moments of clarity from the president (e.g., when he spoke first about the Volcker Rules, but this was spun away within 12 hours by Secretary Geithner and others on the team).

Some limited change may now emerge from the Dodd-Corker compromise. I expect we'll see a version of the "resolution authority", despite the fact this is a complete unicorn -- a mythical beast with magical properties, but not actually useful in the real world.

I've recently asked senior executives from both Goldman Sachs and JP Morgan Chase -- both proponents of a resolution authority -- point blank to explain how a US resolution authority of this kind would help close down their cross-border firms (or Citigroup). I'm still waiting for an answer.

No doubt there will be some sort of "systemic regulator," meaning a group chaired most likely by Treasury. This is a great fuss about essentially nothing. On top of the obvious points about how hard it would be for such a body to act preemptively -- particularly when our next wave of problems will again be cross-border, in terms of exuberant lending into emerging markets -- we actually already have the functional equivalent: the President's Working Group on Financial Markets.

This group, of course, was to used to great effect by Robert Rubin and others in blocking Brooksley Born in 1998 -- to them, she was the systemic threat, because she wanted to regulate over-the-counter derivatives. And the same group was used to no effect whatsoever by Hank Paulson in the run-up to the September 2008 crisis. In the European Union, creating new committees can make a difference; we're better on form over structure in the US -- but when the big banks are so powerful and out of control, we're lousy at both.

Sadly, the consumer protection agency is likely to be gutted as the price of bringing Senator Corker on board. This is of course an affront to everyone who has been -- and continues to be -- ripped off by the financial sector. But we are where we are in terms of the blatant mistreatment of customers in this society. Business people often tell me that we need to "rebuild confidence" in this economy. I couldn't agree more, but how does cheating people -- and refusing to prevent others from cheating -- lead to more confidence?

Despite -- or rather because -- of all the arrogance and misbehavior among our more prominent financial players, we are making progress on the bigger agenda:changing the consensus on what is regarded as safe and sound in all kinds of banking.

Yesterday, Jerry Corrigan of Goldman Sachs told the UK parliament that there was "nothing inappropriate" in the way Goldman helped arrange for Greece to hide its debts. This was helpful -- it essentially acknowledges that the much vaunted "reputation effects" of issuing securities with a top tier investment bank are worth less than zero. Mr. Corrigan affirmed that it is completely acceptable for Goldman and its peers to mislead investors and deceive the markets.

So you can strike out one more purported reason why we should keep massive global financial institutions. They do not enhance transparency, they do not bring clarity, they do not keep governments accountable. Instead, they are paid a great deal of cash to mislead people. What is the social value of that exactly?

With the broader financial picture unchanged -- major banks will make lots of money, while unemployment remains sickeningly high -- legitimate concerns about the practices of Big Finance continue to build. Small and medium-sized banks find themselves increasingly hit by commercial real estate woes. The alliance that has held back reform begins to crack.

Very few people now claim that serious reform is only proposed by people carrying pitchforks; that myth is long gone. The middle of the consensus has started to move, against mega-banks and against dangerous overborrowing by the financial sector. This will be a long hard slog, but we are finally heading in the right direction.

Crossposted at The Baseline Scenario