“Three decades of “Radical Deregulation” freed banks to engage in all manner of reckless behavior. Leaving the status quo in place guarantees? another crisis in the future. Historical patterns suggest the next calamity will dwarf the collapse of 2007-09″
How Would You Simplify the Financial-Reform Bill? A Freakonomics Quorum
Last month, roughly two years into a global financial maelstrom, the U.S. Congress passed a financial-reform bill. It was more than 2,300 pages long, addressing everything from derivatives to consumer financial products to oversized banks. We asked a few clever people a simple question:
If you were writing the financial-reform bill and, instead of more than 2,300 pages, were limited to five specific reforms, what would they be?
The lessons of this crisis are manifestly obvious: Three decades of “Radical Deregulation” freed banks to engage in all manner of reckless behavior. Leaving the status quo in place guarantees?another crisis in the future. Historical patterns suggest the next calamity will dwarf the collapse of 2007-09.
How to fix it? Here are the first 5 ideas out of a longer list in Bailout Nation that not only would have prevented this past crisis, but would also prevent the next one:
- Derivatives: The Commodity Futures Modernization Act of 2000 (CFMA) exempted derivatives such as Credit Default Swaps (CDSs) and Collateralized Debt Obligations (CDOs) from all regulatory oversight. There were no reserve requirements, capital minimums, exchange listings, transparent open interest reporting, or counter-party disclosures. The easiest thing to do would be to repeal the CFMA. Derivatives should be regulated like any other financial products: they should be traded like stocks, bonds, option, and futures – on exchanges, with capital requirements, and full disclosure of counter-parties, with full open interest reported.
- Ratings Agencies: The Nationally Recognized Statistical Rating Organizations (“NRSRO”s) – Moody’s, S&P, and Fitch – slapped their highest triple-A ratings on paper that was actually junk. They did so because investment banks paid them to. This payola was a fatal abuse of their unique regulatory role. The conflict-ridden business models of the ratings oligopoly needs to be repaired. Eliminate the “underwriter pays” structure. Open up ratings to true competition – including open source. Randomly assign ratings agencies so “Rate Shopping” is eliminated.
- Leverage: Prior to 2004, Wall Street firms were limited to 12-to-1 leverage by the 1975 net capitalization rule. In 2004, the five largest banks received a waiver, allowing their leverage to go up to 25, 30, even 40, to 1. Congress should overturn the SEC exemption and legislate that investment banks conform to the pre-collapse leverage of “merely” 12 to 1.? And the SEC should lose its discretion over this issue.
- Restore Glass Steagall: The repeal of Glass Steagall wasn’t the cause of the collapse, but it contributed to the severity of the crisis. The FDIC-insured depository banks should be separated from the risk-embracing investment houses. Prior to the repeal of Glass Steagall in 1998, the market had regular crashes that did not spill over into the real economy:? 1966, 1970, 1974, and most telling of all, 1987.? Wall Street’s occasional bouts of madness did not freeze credit for the real economy. It’s time to return to a banking system divided into two halves: speculative investing and underwriting, and commercial taxpayer-backed depository banks.
- Too Big To Fail: As Nixon Treasury Secretary George Shultz famously quipped, “If they are too big to fail, make them smaller.” The bailouts have reduced competition and concentrated economic power in a few firms. More than 65% of the depository assets are now held by a handful of huge banks – and they are still less than stable. Seven thousand small and regional banks hold the remaining 35%. Bring back competition to the banking sector. Limit the size of the behemoths to no more than 5% of the total US deposits. If we have to break up the biggest banks – JPM, Citi, Bank of America – so be it.
“If it walks like a bank and quacks like a bank, it’s a bank. Bring all banks out of the shadows and into the glare of the regulatory sunlight.”
Financial Reform You Can Fit on the Back of a Napkin:
- If it walks like a bank and quacks like a bank, it’s a bank. Bring all banks out of the shadows and into the glare of the regulatory sunlight.
- Too often financial information is written with two pens. The small font sizes provide enough cover for a lawyer to sign off, but in larger type, they tell a story that is misleading enough to encourage a steady stream of suckers. That doesn’t seem fair. Here’s a different approach. If your firm’s marketing materials lead a random sample of 100 Americans to believe that the mortgage, or credit card, or other financial product is less onerous or risky than it actually is, then your marketing materials are misleading, and your firm is liable for damages.
- An old idea: a Tobin Tax-a small fee attached to every financial transaction. It won’t stop me from saving in my 401(k), but hopefully it would discourage high-frequency traders from wasting their lives hoovering up those nickels that occasionally (and fleetingly) appear on the floor of the exchanges. There’s not a single factory that was built, or a school financed, as a result of their efforts. Indeed, if they weren’t picking up those nickels, those nickels might even remain in our retirement accounts. More generally, let’s encourage the productive side of finance-the part that turns your savings into a firm’s new investment-but discourage financial parasites.
- Allow short sellers. When the regulators struggle to find financial misdeeds, let’s enlist the private sector for help. One approach would be bounties for uncovering financial malfeasance. A cheaper approach is to allow-indeed, encourage-short sellers. The private sector can find out who the charlatans are, bet against them, and then reveal this information to the market.
- Notice that these are all broad legal principles, not bright line rules? The problem with bright-line legal rules is that clever lawyers figure out clever loopholes. But the problem with broad legal principles instead is that regulators are too easily “captured,” befriending those they are meant to oversee. I’m suggesting broad legal principles, but with a twist. I would raise the pay of financial regulators by half, but in return let’s shut down the pathway from regulator to regulated: once you’ve worked at overseeing an industry, you can’t work in the industry for at least five years.
“The captain goes down with the ship…”
Time to realize that capitalism is not about free options. The captain goes down with the ship — all captains and all ships — making everyone involved in risk-bearing accountable, no exception, none. Morally, legally, whatever can be done. That includes the Nobel (Bank of Sweden), the academic establishment, the rating agencies, forecasters, bank managers, etc.
Raghuram Rajan is a Professor of Finance at the University of Chicago and the former Chief Economist at the IMF. He is the author of Fault Lines: How Hidden Fractures Still Threaten the World Economy.
“Reduce the possibility that any financial institution will be too systemic to fail, and ensure that there are substantial classes of securities issued by each of these entities that will lose everything if the entity has to be bailed out…”
- Get the government and its agencies out of the business of supporting housing through tax and lending subsidies. While a cold-turkey strategy will probably be destabilizing, a steady and well-defined path of disengagement can be spelled out (e.g., steadily reduce the mortgage-interest tax deduction over a number of years). Breaking up Fannie and Freddie, privatizing the parts, and sending clear signals that their debt will not be guaranteed by the government (see below) have to be part of the solution.
- Reduce the possibility that any financial institution will be too systemic to fail, and ensure that there are substantial classes of securities issued by each of these entities that will lose everything if the entity has to be bailed out (these securities are more popularly known as contingent capital). In other words, let investors know they will feel the pain, and thereby give them the incentive to put more constraints on bank risk-taking. I would explore the possibility of reducing the extent to which deposits are insured as banks exceed a threshold size.
- If bank boards will not do it on their own, regulators should press bankers to have more long-term skin in the game (that is, money they will lose if the strategy does not pan out over the long run), and let them have more to lose if their bank is ever bailed out.
- Reduce the number of regulators (to fewer than the current bill suggests), let the surviving ones meet regularly in a systemic risk council (which would also have regulatory powers over systemically important financial firms), and ensure that a new Office of Financial Analysis collects timely data on systemic risks and exposures, analyzes it for the benefit of the regulators, but also puts out much of the data and analysis in the public domain so that financial markets can monitor risks directly and keep a check on regulators (I am not going much beyond the bill on this one).
- Get the Fed to focus on financial stability as an important element of monetary policy. The focus on employment and inflation, largely to the exclusion of financial stability (except in a panic), has been an important weakness in its policies.