Obama's Regulatory Brain

The most important thing to know about the 1,500-page financial
reform bill passed by the Senate last week -- now on he way to being
reconciled with the House bill -- is that it's regulatory. If does
nothing to change the structure of Wall Street.

The bill omits two critical ideas for changing the structure of Wall
Street's biggest banks so they won't cause more trouble in the future,
and leaves a third idea in limbo. The White House doesn't support any
of them.

First, although the Senate bill seeks to avoid the "too big to fail"
problem by pushing failing banks into an "orderly" bankruptcy-type
process, this regulatory approach isn't enough. The Senate roundly
rejected an amendment that would have broken up the biggest banks by
imposing caps on the deposits they could hold and their capital assets.

You do not have to be an algorithm-wielding Wall Street whiz-kid to
understand that the best way to prevent a bank from becoming too big to
fail is preventing it from becoming too big in the first place. The
size of Wall Street's five giants already equals a large percentage of
America's gross domestic product.

That makes them too big to fail almost by definition, because if one
or two get into trouble -- as they did in 2008 -- their demise would
shake the foundations of the financial system, even if there were an
"orderly" way to liquidate them. Because traders and investors know
they are too big to fail, these banks have a huge competitive advantage
over smaller banks.

Another crucial provision left out of the Senate bill would be to
change the structure of banking by resurrecting the Depression-era
Glass-Steagall Act and force banks to separate commercial banking (the
classic function of connecting lenders to borrowers) from investment
banking.

Here, too, the bill takes a regulatory approach instead. It includes
a provision barring banks from "proprietary trading," or making market
bets with their own capital. Even if this regulation were tough enough
(and the current Senate bill requires various delays and studies before
it's applied), it would not erode the giant banks' monopoly over
derivatives trading, adding to their power and inevitable "too big to
fail" status.

Which brings us to the third structural idea, advanced by Senator
Blanche Lincoln. She would force the banks to do their derivative
trades in entities separate from their commercial banking.

This measure is still in the bill, but is on life-support after Paul
Volcker, Tim Geithner, and Fed chair Ben Bernanke came out against it.
Republicans hate it. The biggest banks detest it. Virtually every major
Wall Street and business lobbyist has its guns trained on it. Almost no
one in Washington believes it will survive the upcoming conference
committee.

But it's critical. For years the big banks have relied on
taxpayer-funded deposit insurance to backstop their lucrative
derivative businesses. Obviously they want the subsidy to continue.
Bernanke argues that "depository institutions use derivatives to help
mitigate the risks of their normal banking activities." True, but
irrelevant. Lincoln's measure would allow banks to continue to use
derivatives. They just could not rely on their government-insured
deposits for the capital.

Requiring banks to do derivative trading in separate entities would
force them to raise extra capital. But if such trading is so useful,
banks should foot the bill, not taxpayers. Bernanke and others say the
measure would give foreign banks a competitive advantage. Even if he is
right, since when is it up to taxpayers to guarantee profitability at
America's largest banks relative to foreign ones?

The trading of derivatives is not so crucial to the US economy that
taxpayers should subsidize the practice. If the past two years have
taught us anything, the lesson is just the opposite. Derivatives can
generate huge risks unless carefully regulated.

Wall Street's lobbyists have fought tooth and nail against these
three ideas because all would change the structure of America's biggest
banks. The lobbyists won on the first two, and the Street has signaled
its willingness to accept the Dodd bill, without Lincoln's measure.

The interesting question is why the president, who says he wants to
get "tough" on banks, has also turned his back on changing the
structure of American banks -- opting for a regulatory approach instead.

It's almost exactly like health care reform. Ideas for changing the
structure of the health-care industry -- a single payer, Medicare for
all, even a so-called "public option" -- were all jettisoned by the
White House in favor of a complex set of regulations that left the old
system of private for-profit health insurers in place. The final health
care act doesn't even remove the exemption of private insurers from the
nation's antitrust laws.

Regulations don't work if the underlying structure of an industry --
be it banking or health care -- got us into trouble in the first place.
Wall Street's big banks are just too big, and their ability to draw on
commercial deposits for investment banking activities, including
derivatives, will make them even bigger. It will also subject the
economy to greater and greater risks in the future. No amount of
regulation can cure that.

Similarly, the underlying system of private for-profit health
insurance is a key driver of America's bloated and ineffective health
care delivery. We can try to regulate it like mad, but no amount of
regulation will cure this fundamental problem.

A regulatory rather than structural approach to deep-seated problems
in complex industries like banking and health care is also vulnerable
to the inevitable erosion that occurs when industry lobbyists insert
themselves into the regulatory process. Tiny loopholes get larger.
Delays get longer. Legislative words are warped and distorted to mean
what industry wants them to mean.

Both Senate and House financial reform bills exempt "customized"
derivatives from the exchanges, for example, but leave it to regulators
to define what contracts will be excused. Yet many of the derivatives
that caused the most trouble (read: Goldman Sachs and other banks'
deals with AIG) might well be thought of as customized. Another
potential problem: in assigning consumer protection to the Fed, the
bill puts it under Fed chiefs who in the past displayed a patent
disregard of such safeguards (read: Alan Greenspan).

Inevitably, top regulators move into the industry they're putatively
trying to regulate, while top guns in the industry move temporarily
into regulatory positions. This revolving door of regulation also
serves over time to erode all serious attempt at overseeing an industry.

The only way to have a lasting effect on industries as large and
intransigent as banking and health care is to alter their structure.
That was the approach taken to finance by Franklin D. Roosevelt in the
1930s, and by Lyndon Johnson to health care (Medicare) in the 1960s.

So why has Obama consistently chosen regulation over restructuring?
Because restructuring Wall Street or health care would surely elicit
firestorms from these industries. Both are politically powerful, and
Obama did not want to take them on directly.

A regulatory approach allows for more bargaining, not only in the
legislative process but also, over time, in the rule-making process as
legislation is put into effect. It's always possible to placate an
industry with a carefully-chosen loophole or vague legislative language
that will allow the industry to continue to go on much as before.

And that's precisely the problem.