With apologies to the National Journal, here's another highly relevant article. It gets to the core of the ideological disputes that we've noted are at the heart of questions about the role of government. The national government is expected to provide stability to the financial system, but given its complexity, is this a realistic goal? What, is anything, can the national government do to minimize the risks of the marketplace?
FINANCIAL INSTITUTIONS
Is Stability A Realistic Goal?
Can the U.S. government really guarantee the nation's vast and complex financial system? There are few precedents.
Saturday, May 22, 2010by John Maggs
In many ways, the financial reform bill moving through Congress resembles other landmark pieces of legislation. Like health care reform, it tackles a pernicious side effect of America's free-market economy and treats it with a typically light touch by offering a package of incentives and disincentives for businesses and consumers. Instead of forcing banks to become smaller, the bill encourages them to do so. Instead of banning the kinds of home loans that contributed to the housing crisis, the legislation sets up a consumer protection agency that will rely mainly on disclosure to prompt Americans to make smarter financial decisions.
Like other regulatory reforms, the financial overhaul eschews a massive reorganization in favor of shifting oversight functions and responsibilities among several government agencies. The Federal Reserve System will continue to audit big national banks and some state-chartered banks; the two other bank regulators will split the rest, more or less as they do now.
Responsibility for one of the reform package's most far-reaching steps -- imposing the first rules for derivatives trading -- would mostly fall to private companies and big banks themselves, rather than to a government agency. The overhaul package leaves many details to regulators to work out. "It is really just a series of general guidelines," said Vincent Reinhart, a former top Fed official. He supports this conservative approach, saying that it will allow government officials to deliberately work through what rules to change and how to change them.
In at least one way, though, the financial reform plan represents a new approach. Grafted onto the largely familiar array of agencies that regulate banks is a council of top economic officials tasked with counteracting instability in the financial system before it becomes a critical threat. The council will look beyond individual institutions and practices to anticipate bubbles and spot potentially destabilizing financial innovations -- such as the bonanzas that subprime lending and collateralized debt obligations seemed to be a few years ago.
The proposed Financial Stability Oversight Council, as the Senate legislation calls it, is an interagency group of nine people chaired by the Treasury secretary; it would include the chairman of the Federal Reserve Board, the heads of other financial agencies, and one or two other appointees (the House and Senate bills have slight differences). Some of its functions approximate the emergency powers that the Federal Reserve and Treasury have traditionally kept for themselves. But giving the council the job of foreseeing problems and acting to preserve stability in the nation's vast and complex financial system is an audacious undertaking, even for the U.S. government.
"It hasn't been tried before," said Morris Goldstein, a senior fellow at the Peterson Institute for International Economics. "We don't really know what [the council] will do -- a lot, or perhaps not a lot."
If the council doesn't do a lot, then the separate bank regulators might decide to be much more active and attentive than before. Perhaps the Fed, chastened by the near-failure of the financial system, would take a more active approach to its informal role of overseeing Wall Street and the rest of the "shadow banking system." New disclosure rules, although limited, might discourage banks from using derivatives for highly lucrative speculation. Unlike the subprime-fueled housing crisis, the next financial bubble could be safely deflated by the various bank regulators, even if that intervention deprives the banks they oversee of huge profits. "The [bank oversight] system isn't changing that much," Doug Elliott, a former investment banker and a finance expert at the Brookings Institution, said. "There is a hope, I think, that everyone is going to do better."
But if fragmented oversight again yields regulatory failure and threatens another economic meltdown, the "systemic risk council" could play a significant coordinating role. How would the council define instability? Would it intervene only in a crisis that threatens the imminent collapse of the financial system, or would it move earlier to quell turmoil before it could lead to such a crisis? Would the council act to rein in excessive executive pay that could fuel risky behavior? Would it move to deflate a financial bubble, even if that bubble is making people richer? If consumers are borrowing too much, would the council curtail credit? Would it deal with the domestic effects of an international financial crisis? Most important, if the council took any of these aggressive steps, would it be effective?
"We don't know," Goldstein said. "It is an experiment. We'll have to see what it does and how that works."
Like Elliott, Norman Ornstein believes that the risk council won't do much more than sign off on the emergency actions that the government would take in any case to deal with a financial crisis. Ornstein, a resident scholar at the American Enterprise Institute, doubts that the government is about to embark on an uncharted, proactive approach to financial oversight.
Goldstein disagrees. The legislation signals a substantially different and more hands-on regulatory regime, he argues. The repeated promises from President Obama and virtually every member of Congress that expensive bailouts won't be needed (or forthcoming) again have raised the bar, he says. "When lawmakers say 'Never again,' I think there is an expectation that things are going to be done differently, and [the council] is part of that," Goldstein said. "I expect it to try things that haven't been tried before."
We're Not Good At It
The government has long set rules for businesses operating in the market-based economy. Washington has little practice, however, in guaranteeing the outcomes of market activity. The 1,000-point drop in the Dow Jones industrial average on May 6 demonstrated that even in the highly regulated stock market, the government has few tools to prevent a degree of instability that many people would regard as disastrous. Under current rules, only a 30 percent plunge in the market can shut down trading for the day.
In times past, Americans would have blanched at the prospect of the government's guaranteeing the health of an entire industry, even one considered essential to the well-being of the overall economy. In 2009, the Treasury Department loaned more than $100 billion to rescue General Motors and Chrysler, but it put the automakers on a short leash, forcing them to promptly repay most of the money. If they were to falter again, Washington would likely allow them to fail.
The financial system that seized up in 2008 is exponentially larger and more complex than the stock market or the auto industry, and a government promise to maintain its stability is unprecedented.
"When lawmakers say 'Never again,' I think there is an expectation that things are going to be done differently, and [the council] is part of that." -- Morris Goldstein, Peterson Institute for International Economics
To put this commitment into perspective, consider the scope of the health care reform package enacted this year. Imagine for a moment that Washington had empowered a council to guarantee the stability of the U.S. health care system. If medical care, like credit, was scarce or too expensive, the council could intervene to make sure it was affordable and readily available, by acting wherever it chose to head off, say, shocking rate increases, or by guaranteeing medical care to everyone, with or without insurance. This sounds far-fetched because the epic health debate revealed that Americans are hardly eager to embrace government intervention to guarantee such ambitious outcomes.
Compared with many other countries, the U.S. government has tended to take a laissez-faire approach to regulating such essential services as transportation, electricity, and telecommunications. Washington does attempt to preserve the stability of agricultural supply and prices, with only mixed results. Most economists say that the current system of farm subsidies and price controls exists more to boost the farmers' income than to protect consumers.
But even these examples involve industries much smaller and simpler than the financial system, which extends beyond banks to include insurance, mortgage lending, and consumer credit -- sectors that will remain relatively free of federal regulation, even after the regulatory reform package becomes law. The most comparable example of the government ambitiously trying to maintain the stability of markets was World War II and the extensive system of rationing and price controls that the Roosevelt administration used to prevent inflation, hoarding, and profiteering. That intervention was arguably successful, but a more recent iteration wasn't.
President Nixon imposed wage and price controls from 1971 to 1973 to combat inflation and escalating wage demands by labor unions. The move triggered runaway inflation, slow growth, food and commodity shortages, and an era of declining living standards. Economists consider the controls one of the most disastrous economic policy decisions ever by a U.S. president.
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Before The Emergency
Oddly, the debate over financial reform hasn't focused much on the question of whether government can or should try to assume responsibility for stabilizing the financial system. Neither party in Congress has drawn attention to the goals of the systemic risk council or to the very notion that a government body would try to head off instability throughout the financial system before it causes a crisis.
Most of the discussion in Congress has centered on the council's role in managing the shutdown of giant financial companies that fail. The council is supposed to handle this emergency action in an orderly and predictable way, in contrast to the ad hoc, chaotic bailouts and shotgun mergers that took place in 2008 and 2009. This process has been the focus of ideological skirmishes in the Senate between Republicans, who charged that the bill that arrived on the floor would permit bailouts to save faltering banks, and Democrats, who insisted that the opposite was true.
To settle that argument, the first amendment, offered by Sen. Barbara Boxer, D-Calif., simply reiterated that the systemic risk council would have no choice but to break up faltering banks and financial companies rather than bail them out. The amendment passed by a wide, bipartisan margin.
In one form or another, the federal government has always taken emergency action to stem financial panics and other crises that threaten the economy, according to Liaquat Ahamed, author of The Lords of Finance: The Bankers Who Broke the World, a 2009 book on the early years of central banking. Congress established the Federal Reserve Board in 1913 to coordinate emergency action, using the power to make emergency loans to counter bank runs and otherwise manipulate interest-rate policy to maintain liquidity in the banking system. Although the Fed and Treasury took actions during the recent crisis that were messy and in some ways unprecedented in size and scope, the interventions essentially followed past patterns, Ahamed said in an interview.
In Ahamed's view, the earliest days of the crisis made it clear that the United States had to do three things to minimize the risk of a plunge that could wreck the financial system. First, the government needed to bolster the capital reserves of banks, which had used holes in the accounting rules to evade reserve requirements; second, Washington needed to take on increased oversight to prevent excessive risk-taking and leveraging; and third, if the first two requirements weren't met, government would need a more streamlined and effective process to handle emergencies.
Steps to meet the first requirement, he said, are well under way. The Fed and other bank regulators, in coordination with their counterparts in Europe, are expected to issue interim capital requirements in late 2010 or early 2011 and to finalize regulations over the next two years. In the past, banks traditionally had capital reserves of 8 to 10 percent of their total deposits, but through "off balance sheet" transactions and other creative accounting, some big banks had shrunk their reserves to perhaps half this level. "Recapitalization of the banks is happening," Ahamed said. "The banks have been preparing for it."
The emerging legislation intends to provide a smoother and swifter process for the government to seize insolvent banks and sell their assets. This process will also allow regulators to capture and execute nonbank financial companies, such as American International Group, that are large enough to threaten the financial system if they fail.
These two functions were already important government responsibilities, according to Ahamed, but the middle role -- seeking to guarantee the stability of the financial system -- is different. The Fed has been responsible for auditing many of the largest banks, and it has important duties to keep interests rates and inflation low and employment and the economy growing.
The Fed's responsibility for maintaining the overall stability of the financial system has been more ambiguous, especially in recent decades. Although regulators have stepped up its efforts to stabilize the financial system, "it is also true that the financial system is more complex" than a decade or two ago, Ahamed said.
The Federal Reserve has long had close relations with large bank holding companies such as Citigroup and Bank of America (where Fed examiners actually showed up for work every day at their headquarters). Until recently, though, Fed accountants were not as involved in the day-to-day operations of Wall Street banks -- such as Bear Stearns, Goldman Sachs, and Lehman Brothers -- that were some of the biggest customers for the Fed's Treasury bills. The chaos of the financial crisis revealed just how little attention the Fed paid to ensuring their stability and how limited were its powers to help them.
This Time Is Different
Ahamed and others contend that the Fed has traditionally served as a kind of systemic risk council for the financial system. They point to the 1998 rescue of the hedge fund Long Term Capital Management. Worth about $4.7 billion at the start of that year, the fund made a number of risky bets in derivatives that went bad, and it faced the prospect of failure as investors tried to withdraw their money.
Long Term Capital Management was involved with every big bank on Wall Street, and its failure arguably threatened similar runs at other institutions. Moreover, a separate and less quantifiable risk was a crash in the value of privately traded financial derivatives of the kind the fund held. The big banks' direct business with the hedge fund represented a few billion dollars in potential losses, but their exposure to the derivative market as a whole was much larger, and that was a major factor in motivating the Fed to act.
The rescue that Federal Reserve Board Chairman Alan Greenspan organized in September 1998 demonstrates how different the new risk council will be. The government used no taxpayer funds to bail out Long Term Capital Management, and the Fed did not even use its emergency lending powers, as it did during the recent financial crisis. Instead, Greenspan and officials at the Federal Reserve Bank of New York were able to cajole the fund's creditors to invest from $100 million to $300 million each, approximately what each stood to lose if it failed. Of course, in 1998, in the midst of the dot-com boom, the rest of Wall Street was otherwise flush with cash, in contrast to 2008.
A hallmark of the Greenspan era, from 1987 to 2006, was the Fed's unwillingness to serve as the kind of guarantor of financial stability envisioned in the plan for the Financial Stability Oversight Council. At the same moment that Long Term Capital Management's derivatives trades were souring, Greenspan was otherwise engaged in killing off an effort by Brooksley Born, then the chairwoman of the Commodities Futures Trading Commission, to regulate derivatives. At multiple congressional hearings, Greenspan argued successfully that no oversight was needed -- because the self-interest of big banks and investors would be more effective than any government agency in controlling risk and maintaining stability.
Since then, Greenspan has expressed wonderment at the failures of such market discipline during the financial crisis, but he has not admitted that he might have been mistaken about unregulated trading in derivatives. Ten years after his tidy and privately financed rescue of Long Term Capital Management, one type of unregulated derivative was at the center of the subprime mortgage meltdown, and a related derivative underlay the $182 billion bailout of AIG, which at last count is expected to cost taxpayers $50 billion.
Reinhart has low expectations for the systemic risk council and the rest of the regulatory overhaul because he thinks that Congress is aiming at the wrong target -- preventing banks from becoming "too big to fail." Reinhart, a former director of the Fed's Division of Monetary Affairs, believes that in the 24 years since the government made major changes to the tax code, banks have exploited weaknesses in accounting rules. Banks' "splintering" of their balance sheets, he says, made it impossible for regulators to understand what was going on, for the market to exercise the discipline that Greenspan was depending on, and even for managers of the banks to understand the risks that had accumulated.
Washington's crucial decision to allow Lehman Brothers to fail in September 2008 came after the Treasury Department tried for a week to sell off pieces of the company. The stumbling block, Reinhart says, was that neither the prospective buyers nor Lehman's management really understood the company's liabilities, which at that point were buried in the more than 2,000 affiliates and "special-purpose vehicles" that Lehman had created to conceal its debts. At Citigroup and banks much larger than Lehman, the complications were even bigger, and they got government bailouts because no one wanted to find out what would happen to the counterparties to those trades if all of the banks' activities dissolved. "The problem wasn't that [the banks] were too big to fail -- they were too complicated to understand," Reinhart said.
"We are giving the [risk] council a nearly impossible job," he says, because the complications of stabilizing an entire financial system are almost unimaginable. Reinhart asks rhetorically whether regulatory reform will make the balance sheets of big banks any easier to understand. "If not, then I think the council has a mission it can't accomplish."
The Peterson Institute's Goldstein is more optimistic. He believes that the council will try to use "countercyclical" policy to respond to changes in banks' level of risk-taking, even in the absence of cash-flow problems. As a hypothetical, if banks invent a home mortgage or debt instrument that is producing big profits but arguably creating new risks for the financial system, the Financial Stability Oversight Council could pre-emptively raise capital reserve requirements based on the level of this newfangled lending, he argues. Another countercyclical option, anticipated in the Senate version of the legislation, is a requirement that banks issue a certain level of "contingent capital," bonds that automatically convert into equity if a bank falls into financial difficulty. This would spread the pain of the bank failure to debt holders as well as stockholders.
Would the risk council use such countercyclical means to try to head off the next financial bubble? Goldstein thinks it is possible, but Reinhart is doubtful. When Greenspan issued his famous warning in late 1996 about "irrational exuberance" in the stock market, Reinhart said, no one wanted to listen. The market doubled in the next four years, until the dot-com crash, and Greenspan, according to his memoirs, concluded that even Fed chairmen are powerless to puncture a financial bubble.
No elected or appointed official would risk the political fallout from taking action against a possible bubble, Reinhart argues. At best, a lot of people will be poorer. At worst, he said, government officials risk destabilizing rather than stabilizing the situation.
If we are lucky, former investment banker Elliot says, the risk council's existence will be enough to deter excessive risk-taking. Depending on whether the House or Senate version is enacted, either a two-thirds vote or a simple majority of the council could force a company to sell off some divisions, even if it wasn't yet in financial difficulty. More likely though, Reinhart warns, it will take another crisis to move government to directly address the complexity of large banks that is at the root of systemic risk. "I fully expect it," he said.
