|This is the second article in a three-part series on the FCIC and financial regulatory reform. The article originally appeared on the New Deal 2.0 blog, where I am a Braintruster.|
As a candidate, President Obama decried the removal of Glass-Steagall without an adequate regulatory replacement. In March 2008, speaking at Cooper Union in New York City, he said:
“..we have deregulated the financial sector and we face another crisis. A regulatory structure set up for banks in the 1930s needed to change, because the nature of business had changed. But by the time the Glass-Steagall Act was repealed in 1999, the $300 million lobbying effort that drove deregulation was more about facilitating mergers than creating an efficient regulatory framework.”
Now, Secretary Geithner has proposed a revised regulatory structure, that relies on a super-regulator to oversee entities that are "too big to fail." Last week, in testimony before the House Financial services Committee Paul Volcker, the former Chairman of the Federal Reserve, expressed skepticism about the concept of adequately regulating banks that were "too big to fail" and suggested a system that separated high risk activities from commercial banking. He effectively advocated an updated version of the Glass-Steagall Act, although Volcker avoided using this term . As discussed below, I agree.
The decisions we make in our current effort have the potential to influence the nation's prosperity for at least a generation. The principal job of the financial system is to allocate capital appropriately. When it does its job well, the economy has the greatest chance of thriving. When it performs poorly, productive activities are unable to acquire the capital they need. Today, we are experiencing the results of an extreme failure on the part of the financial system to direct capital appropriately.
With so much at stake, the American people deserve a full explanation for why one vision of the financial system is superior to another. As a consequence, this post is linked to a petition asking the Financial Crisis Inquiry Commission and the Treasury Secretary to explain in detail their reasons for recommending, or not, a system that relies on a highly concentrated, limited number of interlinked financial entities who are clearly “too big to fail,” and who mix activities that are vital to the health of the nation with high risk activities that are frequently described as a casino.
To date, I have been shocked to discover that I cannot discover any coherent statement by the Executive Branch which explains the rationale for its current proposal as opposed to the type of system advocated by Paul Volcker and others.
This petition does not advocate a specific position. Rather, it is a request that the Financial Crisis Inquiry Commission fully meet its mandate to inquire, and that the Executive Branch fully explain its reasoning.
In our democracy, this request for a full explanation should be unnecessary. However, I am promoting this extra level of public engagement to ensure our process of full public debate works.
My conclusions, as described below, may change once I see the detailed explanations requested in this petition. However, at this moment here is why I believe we will be a far healthier society with smaller less integrated financial institutions.
I subscribe to the view that we need an updated version of the Glass-Steagall Act that ultimately restricts the activities of financial institutions into one of four types of entities: commercial banks, insurers, investment banks (including underwriting, brokerage activities, and securities related advice), and speculative trading. In this updated vision of a Glass-Steagall 2.0, investment banks would not be permitted to issue securities and operate hedge-fund like trading operations.
The definition of freedom, going all the way back to Athens, is the ability to do whatever you want provided you don't hurt anyone else. Since the financial system has now caused misery for millions of people and received special subsidies from the federal government, the notion that financial institutions have an inherent right to operate in any and all lines of business is simply wrong. The central question must be what's best for the nation.
There are five principal questions that should guide the development of financial system reform.
- First, how do we restore trust and confidence in both our financial institutions and in the self-correcting nature of our democracy?
Right now, millions of Americans are suffering economically. Millions of additional people will suffer before this Great Recession ends. This is a cruel reality. Americans who thought they would have comfortable lives are waking up to diminished circumstances. They are also increasingly concluding (right or wrong) that rather than increase the total income of our society the financial sector engineered a huge transfer of income from the middle to the top. People are increasingly angry, cynical and mistrustful.
All of this means that whatever financial reform is undertaken the government must demonstrate that our nation is not, as MIT economist Simon Johnson asserts, run by financial Oligarchs.
The public perceived the financial bail-outs as favoring Wall Street, at the expense of Main Street. In addition, millions of suffering people feel like they are suffering, while those at the top--who caused the crisis--are not sharing the pain. We are at a moment when cynicism, mistrust and anger could grow to even higher levels in our society. As I wrote in It Could Happen Here, such a reaction move us down the dangerous path to political instability.
The parallel to the era of the New Deal is real. By breaking up the financial conglomerates, the Glass-Steagall Banking Act of 1933 demonstrated that America was run for the benefit of the general population, and not an elite group. The same symbolism would hold true today. A Glass-Steagall 2.0 would send a strong, and much-needed, message to the American people that we remain a vibrant, self-correcting democracy.
- Second, what does experience tell us about regulatory policy?
The creation of a super-regulator, charged with monitoring entities deemed "too big to fail," will necessarily lead to an enormous regulatory structure. Imagine both the complexity and lack of certainty that will be involved in such a regulatory effort.
In his testimony before the House Committee, Volcker similarly expressed concerns on this issue:
...However, the clear implication of such designation, whether officially acknowledged or not, will be that such institutions, in whole or in part, will be sheltered by access to a Federal safety net in time of crisis; they will be broadly understood to be "too big to fail."
Think of the practical difficulties of such designation. Can we really anticipate which institutions will be systemically significant amid the uncertainties in future crises and the complex inter-relationships of markets? Was Long Term Capital Management, a hedge fund, systemically significant in 1998? Was Bear Stearns, but not Lehman? How about General Electric's huge financial affiliate, or the large affiliates of other substantial commercial firms? What about foreign institutions operating in the United States?
Regulated markets function best when we are able to establish a few Bright Lines, with clear rules that are known by all the players and, to the maximum extent possible, limited uncertainty. One of the virtues of breaking up firms by function is it establishes bright lines, and as a nation we know how to run the resulting competitive markets effectively.
In Freedom from Fear, the Pulitzer Prize winning New Deal historian David Kennedy, describes these bright lines as one of the virtues of the original Glass-Steagall Act. He also notes that the Roosevelt Administration faced very questions about regulating large financial institutions that are remarkably similar to what we face today:
...the New Deal confronted a choice... it could accede to the long-standing requests of the major money-center banks--especially those headquartered around Wall Street--to relax restrictions on branch and interstate banking, allow mergers and consolidation, and thereby facilitate the emergence of a highly concentrated private banking industry, with just a few dozen powerful institutions to carry on the nation's banking business...But the New deal did neither...[it separated commercial and investment banks and established what would be the FDIC]
...These two simple measures did not impose an oppressively elaborate new regulatory apparatus on American banking, nor did they levy appreciable costs on either taxpayers or member banks. But they did inject unprecedented stability into the American banking system."
With “These two simple measures” FDR and his Administration made the hard choice that ensured a stable system for over half a century. Rather than accept the status quo, they created a new system that operated effectively, and with far less regulatory oversight than would otherwise have been required. Our contemporary government must now act with a similar resolve.
- Third, what solution will minimize risk while ensuring that our financial system fulfills its responsibility to appropriately allocate capital?
This question has two parts. First, the absolute failure of the existing financial system suggests there is no reason to believe larger institutions allocate capital more efficiently than smaller, focused entities. In fact, recent events suggest that larger horizontally integrated institutions may do the reverse. It's possible that financial entities in multiple lines of business are systematically allocating capital away from the patient investments that most benefit our society and channeling capital into short-term high-risk activities involving trading and speculation.
So, the answer to this question revolves around what types of entities create the greatest risk for the society, sine greater size does not seem to lead to more efficient allocation of capital. The answer is straightforward. As many observers have repeatedly noted, institutions that are too big to fail pose a clear risk to the financial system.
In fact, Neal Barofsky, the Tarp Inspector, recently expressed sentiments that our level of risk has increased during the past year. Since the start of the financial crisis, the size of the remaining banks has increased, making the system more concentrated and more dependent on the few remaining players. As a consequence, Barofosky believes the financial system "may now be a far more dangerous place".
Second, the potential problems associated with large financial institutions is not simply their size, but the extent to which they inevitably become interconnected.
Third, if there is one thing we learned in this crisis it’s that regulators must be willing to regulate. The Federal Reserve, which the Geithner plan proposes as the super-regulator, failed utterly in preventing the sub-prime mortgage debacle. Do we really believe that any entity will be able to effectively regulate, or even understand, the risks associated with the activities of our existing financial conglomerates? In contrast, smaller focused institutions will pose less risk to the system if one fails and be easier for regulators to understand.
Fourth, the bright lines provided by clear legislation create market guidelines that are far less likely to be arbitrarily weakened with changes in the philosophy of the Executive Branch.
Finally, a system composed of smaller focused financial institutions will be more resilient as different types of institutions will be following different business models. Today, our limited number of financial institutions seem to gravitate to toward the newest, profitable financial innovation. If the innovation goes south--such as securitized mortgages--all of the institutions, and the entire system are endangered. Smaller, focused entities must necessarily pursue a plethora of business models, which provides some immunity from this type of contagion.
- Fourth, what impact will the policy have on competition and accountability?
As many others have said, institutions that are too big to fail are ultimately not accountable. Period.
It is this lack of accountability which has severely undermined the faith of the American people. In the absence of the possibility of the downside, discipline disappears, high risk is the obvious course of action, and the rest of the society wonders why entities that never pay the price for failure warrant high compensation if they succeed. In a capitalist economy, risk and reward are meant to be intimately linked.
There is another important factor at work here as well. The original Glass-Steagal Act effectively served as an antitrust constraint in the financial sector as well. Since the beginning of the crisis, concentration in the financial services industry has risen. By correctly shaping a Glass-Steagall 2.0, we can restore higher competition to this arena.
- Fifth, should the plan give special deference to the status quo?
The answer must be no. First, shareholders remain whole. They receive stock in each of the individual entities created from a larger whole. Second, none of the benefits associated with financial supermarkets that were articulated at the time the original Glass Steagall act was repealed actually materialized.
In his April 2009, Joseph Stiglitz testified before the Joint Economic Committee of Congress and eloquently addressed this question:
"The only justification for allowing these huge institutions to continue is that there are significant economies of scope or scale that otherwise would be lost. I have seen no evidence to that effect. Indeed, as I have suggested, these big banks are not responsible for whatever dynamism there is in the American economy. The touted synergies of bringing together various parts of the financial industry have been a phantasm; more apparent are the conflicts of interest—evidenced so clearly in the Worldcom and Enron scandals earlier this decade. In short, we have little to lose, and much to gain, by breaking up these behemoths, which are not just too big to fail but also too big to save and too big to manage."
This discussion is not a statement that,as some have asserted, repealing the original Glass-Steagall Act was the cause of the current financial crisis. Rather, a Glass-Steagall 2.0 would address new realities, and would benefit from what we have learned in this crisis. It is, however, a statement that the fundamental approach of simplicity embodied in the original Glass-Steagall Act is how we should now orient our policies.
Whether or not you agree with this proposal, please sign this petition. The essence of a democracy is a full, often messy, generally contentious debate. What’s most important now is that this happen, and that everyone be as informed as possible.