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."