Debate about the root cause of the financial crisis has raged for over a year. With blame to go around everywhere, there is no clear winner and many losers. Ill conceived government policies to stimulate single family home ownership, overly accommodative monetary policy, and explosive growth of a loosely regulated and poorly managed shadow banking system designed to disburse risk ….all helped fuel the crisis. Now that bank taxpayer bailout funds are being repaid and fears of a nationalized banking industry allayed (at least until the next “too big to fail” runs into trouble), what is an appropriate level of government involvement in the banking system?
Recent history suggests the key to creating a successful and healthy banking model lies in finding the optimal balance between free-market economics and government regulation. As this is more or less a zero-sum game, let us focus on the regulatory side of the equation. Two recent legislative initiatives could greatly re-shape the banking and financial services industry.
The
Restoring American Financial Stability Act of 2009 proposed by
Senator Christopher Dodd offers a number of alternatives to Barney Frank’s
financial reform legislative agenda including:
- Consolidation of bank regulatory activities under one empowered organization,
- Significant reduction in FDIC and the Federal Reserve’s role in banking oversight,
- Government intervention to soften the market impact of “too big to fail” firms gone bad and
Separately,
Senators Maria Cantwell and
John McCain introduced bi-partisan legislation to effectively resurrect Glass-Steagall a decade after it was abolished. The
Cantwell-McCain Legislation would generally:
- Prohibit commercial and investment banks from affiliating in any manner
- Require legal separation of officers, directors and employees
- Prevent commercial banks from engaging in insurance activities
- Create a one year transition period for compliance
If forced to choose (which of course we aren’t) the Cantwell-McCain proposal represents a good alternative. There are many who criticize the idea of creating a 21st Century Glass-Steagall Act on the grounds that it is outdated, and simply does not satisfy the needs of the modern financial system. The fundamental premise is that large global corporate clients have sophisticated financing needs that only a fully integrated (‘integrated’ meaning the full menu of commercial banking, investment banking and sales and trading products is offered under one umbrella) global financial organization can provide. Looking over the wreckage left behind from the recent financial crisis, it’s hard to see the wisdom in that argument. It seems the separation of federally insured bank deposits from risky trading and investment banking activities would strike the requisite balance between free-market capitalism and the heavy hand of government (the Dodd bill calls for the bail-out of “too big to fail” firms, up to a $4B ceiling). If the Cantwell-McCain legislation is passed, independent commercial and investment banks would be free (short of mandated max leverage ratios and/or higher risk based capital requirements) to individually pursue profit maximizing strategies, without the risk of robbing Peter to pay Paul.
So what is an appropriate level of government involvement in the banking industry? Surprisingly it may not need to be much more, or extremely complex. Simply separating those businesses with an implicit government backstop (and I am certainly not talking about any “too big to fail”) from capital raising and trading activities might be just enough.
A little better balance between the profit motive and public accountability might help as well. Greed is good. Opacity is unacceptable. Suicide is always to be prevented.
What do you think……..?
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5 comments:
If you combine the Cantwell-McCain proposal and the Obama tax on Banks, you end up with a lose-lose situation for an Investment Bank. If they can't take deposits, then their liability tax base is higher from a tax perspective. What does this do for capital markets overall ?
Badri.
Reinstating Glass-Steagall is one of many simple solutions to a complex crisis. Justification may be found in John Mack’s comment to the FCIC that the problem was that many players “ate their own cooking,” i.e., continued to own much of the ostensibly low risk paper that they had structured and underwritten but either could not sell off or rationalized to be high RAROC positions. However, as the proponent of Glass-Steagall as an alternative does state, markets have changed a lot since the head of syndicate at Morgan Stanley ran the investment grade corporate bond market, which was then the only game in town outside the banks. As a generality we need large, complex and diverse financial institutions because that is what the clients and clienteles actually need. Moreover, unilateral restoration of Glass Steagall would return the U. S. to the situation where its financial institutions were at a major international competitive disadvantage. And in today’s markets, the restored investment banks would still have to be large and complex, just as were the late, lamented Bear, Lehman and Merrill. This would still raise the same systemic issues, which relate to market structure more than institutional size per se. Although U. S. regulators and politicians tend to adopt a Rumsfeld-type approach to the collective work of the Basel Committee, that is where the regulatory action should be in terms of developing adequate capital, liquidity management, process, people-management and other standards to ensure sound ongoing financial system development. Above all, the Committee is going to have to be tough on real estate financing of ALL types, which seems where the majority of financial crashes originate.
Philip D Sherman
psherman@shermanfincon.com
From the perspective of individual investor, "The back to the basic" is crucial. I support the Cantwell-McCain proposal in the spirit as individual does not need a complex financial instituation and the truth of the cross-selling just increase the cost and the risk of individual investors. There is a room for the independent financial planner to do the financial job for individual investors. And from the crisis this time, we also see that the bigger one just can not reduce its risk and cost somehow to individual investors as they desperately want their customers to buy their comparative-inferior financial products not matter thery are mutual funds or structured products. The professional job of financial planning is due to the independent financial planner not to the complex financial institution.
"short of mandated max leverage ratios and/or higher risk based capital requirements"....
The question is why not? Huge leverage, without the capital to back it up, is one of the reasons for failures. Further, using the deposits from pure banking, then leveraging further with an aim towards proprietory trading/profits and volumes far in excess of customer business needs,adds exponentially to risk should be controlled. Risk frontiers determined for each large financial institution (instead of one suit fits all)through a nuanced approach.
System should depend less on rules and regulation and be self-sustainable self-governing entities. Creating the system too efficient is not good, just like you can't walk on a frictionless surface. Frictionless-ness is good is other cases, say in ball bearings makes the machinery run better faster etc. We have allowed the financial system to be too friction less. There is a lot of shanigans going on. Banks are not lending. Money is getting misappropriated. Short selling ban is a bad idea. The old fiscal policy / monetary policies are at the verge of break down, they really dont work well to begin with. All derivatives are based on a transaction that is done with zero cost, for instance, Futures on stocks cost nothing to enter into because you are not really buying or selling anything NOW; it will happen in the future. Concentrate only on the "cost nothing part". Swap transactions cost Zero dollars to enter into. Any kid or defunct bank can enter into a swap, so to speak. A CDS is a swap also; you a pay premium to buy protection on agreed frequency but and it costs nothing to enter into either. It is a building block for CDO and CDO squares and the tranches. It is very easy to destablize the financial system (thanks to the Black Swans author, Dr Taleb). If you buy a million Out of money puts (put options) the seller is forced to hedge himself and the hedging is done by selling the futures( the zero cost creature). That depresses futures prices, that starts a wave of other related selling. Flash crash is another example which amplified high frequency trading madness, which is a result of near zero transaction costs. My idea revolves around charging a fee to place these zero cost transactions. The fee goes to the government for social security and revitalizing economy and rehabilitate the displaced day traders and financial trading houses. We need to be a bit benevolent. The idea is to allow the genuine hedges to be traded without the fee. This will help main street manage risk and grow business. Government will allow genuine hedgers, like oil producers or utilities trying to deliver or consume oil, and CHARGE THE SPECULATORS TRANSACTION FEES. I think the transaction fees as opposed to taxes is better and has to be paid at the time of doing the trade. Take an example of futures contract. When the futures contract is bought or sold into an account, it will be charged a fee. When the futures contract is consummated by actually delivery or receipt, the transaction fee will be refunded. This way the speculator will pay the fee and the genuine hedger will not. This will discourage speculation by even genuine hedgers and keep them honest. The amount of transaction fee should be significant enough, and definitely more that the just normal bid and ask spread. I am hoping we can find an optimal fee that is significant enough to dry up meaningless speculation but not the liquidity. The drawback is that cost of providing liquidity will go up. But it seems that a speculator will provide liquidity if the gains are there, except now we lure him or her away from just scalping pennies. and the benefits are huge. A CDS +High yield bond = Treasury bond. If you own a high yield bond or a corporate bond you can write a CDS for that entity. To sell a credit protection(CDS) the seller should own a proper Bond to qualify as a genuine hedger. These are just a few examples. This will provide the regulator and auditors a simple and easy mandate. In the risk management literature I read that banks need only meet the reserve requirement and capital adequecy as dictated by regulators BASEL etc, AND if the loss is higher than that then government has to come in. I think that is absolute baloney. We know it causes moral hazard. We have seen it. Government and tax payers need to get out of business of supporting the banks and business that they dont understand.I totally disagree with this. It is creating a huge chain of dominos, ready to fall. We need to design each system to be self-sustaing. This is a step in the process.
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