100 Treatises

Obama Starts to Get It

President Obama recently announced new banking and financial reforms that indicate that while he clearly still doesn’t quite grasp the underlying economic and financial structures that fostered the crisis, he’s getting there. The Economist reports:

Though not a full return to Glass-Steagall, the law that separated commercial banking and investment banking in the wake of the Great Depression (and was repealed in 1999), [the new reform] is at least a return to its “spirit”, as one official put it. Reflecting the possible dent it could put in profitability, bank shares tumbled, pulling stockmarkets down sharply around the world.

Nowadays, if the big bank shares are tumbling, chances are you’re doing something right. That’s because their business models are shot through with flaws, and the kinds of things that benefit them (like unlimited state subsidies) are precisely the kinds of things that are anticompetitive and harmful to a well-functioning economic and financial system. Moving on, the Economist writes:

The first half of the plan concerns restrictions on the scope of activities. Banks that have insured deposits, and thus access to emergency funds from the central bank, would not be allowed to own or invest in private equity or hedge funds. Nor would they be able to engage in “proprietary” trading—punting their own capital—though they could continue to offer investment banking for clients, such as underwriting securities, making markets and advising on mergers.

The second part focuses on size. Banks already face a 10% cap on national market share of deposits. This would be updated to include other liabilities, namely wholesale funding. The aim is to limit concentration, which has increased greatly over the past 20 years, accelerating during the crisis as healthy banks bought sick ones. The four largest banks now hold more than half of the industry’s assets.

The first part has the right spirit—to limit the scope of activities, what a given institution can and cannot do. Here’s the problem: it’s backward-looking, not forward-looking. Note that institutions with insured deposits “would not be allowed to own or invest in private equity or hedge funds.” That seems perfectly reasonable, and it is, except for the inconvenient truth that in 20 years’ time, “hedge funds” may very well be obsolete. Financial and economic innovation ensure that over time, regulations that are tailored too closely to current conditions, current paradigms and current business models are inevitably rendered impotent. Given the relative infrequency of this kind of financial crisis, by the time something comparable is capable of occurring years from now, we can rest assured of two things, (1) that the character of finance, and of banking and investment practices, will have changed significantly, and (2) that the character of regulation will not have changed meaningfully at all.

That’s why a more explicit return to Glass-Steagall or something like it—which would deal with the basic kinds of activities (taking commercial deposits versus playing the stock market, for example), rather than the kinds of firms that do those activities (your local bank versus a Greenwich hedge fund)—would be much more effective and long-lasting. Indeed, Glass-Steagall seems to have been a quite successful piece of legislation, remaining relevant for many decades (from the 1930s until the turn of the century), despite the obvious changes in finance during that time.

In addition, the continued ability for deposit-taking institutions to engage in investment banking (precisely one of the hallmarks of Glass-Steagall was to separate the two) is troubling, because investment banking is not a particularly low-risk activity.

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Some of the biggest problems with the Obama and Democratic reform plans currently in play have to do with a knee-jerk reaction toward bigger government, new agencies, more regulators and increased power. As Nicole Gelinas of the Manhattan Institute has argued, the best ideas for regulation are often the old ones that have been around for a while, and that simply need to be updated, reinforced or just plain executed for once.

Some of her reasonable suggestions include the following:

… the government must once again insulate the core economic functions of long-term borrowing and lending from potential short-term excesses. The government can do this by requiring financial institutions to hold uniform levels of capital against all of their investments — cushioning them from some losses — so that firms cannot game the system by structuring some securities to avoid robust capital requirements. Government regulators should also require financial firms that depend disproportionately on short-term lenders for their own funding to hold more capital.

Note that this kind of an approach would be ingenious in the sense that it would allow government officials to adjust the percentage level of capital requirements in the same way they adjust tax rates, for example. Depending on new analysis or changing priorities, regulators could quickly, efficiently and straightforwardly alter the capital requirements. Just as tax rates are tied to the amount of income or the type of activity, the capital requirements could be tied to the amount of assets or the type of investment or financing activity, rather than what the firm is called or how its business model or prospectus reads. Remember that we already have a strong precedent for management of capital requirements: the central bank already imposes such rules on commercial banks as a tool of monetary policy.

Consistent with activity-based rules, as opposed to firm-based rules, Gelinas says:

… the government must re-impose clear, well-defined limits on activities such as borrowing for speculation. Financial firms should not be able to make hundreds of billions of dollars in promises with negligible cash down, as the insurance giant American International Group did through unregulated financial instruments called credit-default swaps. Nor should regular Americans be able to purchase homes with zero cash down, leaving them — and their lenders and the economy — unduly vulnerable to declines in the values of those homes.

So it looks like straightforward, common-sensical rules for lenders and borrowers of all sizes and scopes can be found being discussed on both sides of the political divide. One hopes that the powers that be are listening. Otherwise, we can all safely rest assured that a new, equally destructive financial crisis is looming on the historical horizon.

MORE ARTICLES:

“Breaking” the Banks

Financial Regulation: New Battery, Same Car

Barack Obama 2012: Why he may win reelection, part one