Reform and Its Obstacles

Eighteen months into the greatest economic crisis since the Great Depression, the United States government has not enacted significant financial reform. Nor is the legislation now pending in Congress likely to deliver the profound change we need.

When the U.S. Treasury secretary tells us that the bailouts of large complex financial institutions, however distasteful, were necessary to save the economy, he is telling us two things -- one spoken and one unspoken. He explicitly states the need to give these behemoths taxpayer funds because if large institutions are allowed to fail, we will get dragged down with them into a depression. What's not stated clearly is that these spillovers from finance to the larger economy are also grounds for very substantial financial regulation prior to the onset of a crisis -- the proverbial ounce of prevention.

We need new laws and a new regulatory ethic to arrest the dominance of a financial sector that looms too large on our economic landscape. No one can argue that an industry that reaped 41 percent of all corporate profits before the crisis, and caused so much enduring damage, contributes to the economy anything on that order of magnitude. It is emblematic of the power of Wall Street that self-proclaimed deficit hawks, so keen on entitlement reform, fail to exhibit comparable zeal when it comes to preventing catastrophic events that will add at least 30 percent to the ratio of national debt to gross domestic product. One more financial crisis and America's public finances will resemble Italy's.


What should be done? There are a few key principles associated with proper reform. They are not hard to identify but very difficult to legislate, given the sheer power of the financial industry.

Drastic simplification is the core need. That means replacing complex, opaque instruments and contracts with simple and transparent ones. This will allow investors and consumers to understand what they are buying. Simplification will make it possible for top management at large financial institutions and regulators to regularly monitor the value of assets and the condition of a firm's balance sheets.

A related imperative is to reform off-balance-sheet practices that are really just evasion schemes to increase leverage. On the eve of the crisis, leverage ratios of 30 to one and beyond were commonplace. When you climb up that high, it hurts more when you fall and have less cushion on which to land. We need to restore the integrity of pricing. Assets need to be marked to their market value rather than valued according to abstract models that may bear little resemblance to what they could be sold for. This reform would restore adequate capital buffers.

A third principle of financial reform is simple usury prohibition. The plain mathematics of interest rates of 30 percent cannot be sustainable at low levels of growth and inflation. Once caught in a vortex of interest rates of this magnitude, citizens have little hope of escape. This is not a product of reckless borrowing but the unstable logic of rates moving on outstanding balances from 7.99 percent, where finances can be managed, to 30 percent, where you cannot keep up.

Fourth, we need to align the social and private incentives of taking risk. Separating activities that are extraordinarily profitable because of inherent conflicts of interest, such as the conflict between in-house proprietary trading and executing customer business, is one example. Risky activities must be prohibited for firms under the protective umbrella of deposit insurance.

Large, complex financial institutions must be subjected to market and regulatory discipline, rather than being indulged as "too big to fail." Thanks to that premise, such institutions enjoy a lower cost of funds. This competitive advantage, coupled with ever-larger proportions of the nation's balance sheet being under a protective umbrella, encourages excessive risk-taking. The premise that an institution is too big to fail also anesthetizes creditors from the need to exercise diligence against the risk of failure. This is the "doom loop" that Andrew Haldane of the Bank of England identifies as the consequence of failure of reform, leading to an ever-larger crisis.

On this point, there is a clear consensus among experts at the Bank for International Settlements and the Financial Stability Board, though not within the U.S. Congress. Reform of "too big to fail," at minimum, would include systems for resolution of failed financial companies that are harmonized internationally; a vast increase in the capacity of regulators to assess the real-time condition of large, complex institutions; exposure limits on cross-firm asset-holding to deter contagion; and derivatives reform so that balance sheets can be understood and monitored.

A simple menu of what we need includes:

  • Derivatives reform;
  • Off-balance-sheet reform;
  • Rating-agency reform;
  • Restructuring of housing finance;
  • Separation of risky activities from the financial safety net;
  • Separation of activities that have inherent conflicts of interest within a firm;
  • Legal resolution powers for large failed institutions, with consistent cross-border standards;
  • Significant increase in resources and salaries for supervision, examination, and regulation; and
  • Consumer financial protection.
  • Yet despite appearances, none of these reforms is truly included in pending legislation. Why can't we get real financial reform? Some argue that the issues are so arcane that the public can't comprehend the differences between real and cosmetic reform. But there is abundant evidence that the public is not so easily deceived. In fact, the widespread rage at Wall Street, which pundits decry as "populism," is really quite valid. Elected officials often disparage public intelligence when the public wants something that is in conflict with the powerful. It is their form of denial when their jobs are in peril.

    Given the high cost of campaigning, many politicians follow the wishes of donors rather than pursuing strong policy. This temptation will only worsen as a result of the recent Supreme Court decision in Citizens United v. FEC, allowing unlimited corporate political spending. We have one too many markets. The market for the purchase of rules of the game is far too strong when behemoth financial institutions have tens of billions of earnings at risk and legislation can be blocked or modified by contribution--hungry legislators trying to survive with high unemployment and an angry electorate.

    Elected officials are trying to reconcile their need to appease donors in the financial sector with recognition of the legitimate demands of an enraged public. But they cannot do both. Public--opinion polls such as the recent Pew Survey on reform reveal acute public concern and awareness of the issue of financial reform. Anger at the banks was clear in Massachusetts during the January special Senate election. President Barack Obama's advisers must have recognized this, too, as they briefly trotted out Paul Volcker before quietly setting aside his proposals for financial reform. Gallup polls show that the Federal Reserve is now less popular than the Internal Revenue Service.

    So with the dual needs of campaign finance from Wall Street and demands from the public, our legislators are on course to engage in a theatre of pretend reform centered on two elements: strong consumer financial protection and bold declarations that they have ended "too big to fail." But inside the triangle of negotiation between House, Senate, and administration bills, with lobbyists working behind the scenes, there is little real reform that will accomplish these tasks.

    Most of the needed reforms are either ignored or addressed only cosmetically in pending legislation. The Dodd bill would give the Federal Reserve the proposed Consumer Financial Protection Agency. This is an odd pairing to say the least. The biggest systemically significant institutions are convinced that the Fed has to court them to get proper information for supervisors and examiners; it is difficult to believe that the Fed will antagonize the large banks by enforcing laws on the consumer frontier. These two missions are incompatible and one can only surmise that the consumer protection will be enacted in spirit more than implemented in substance.

    More generally, after their failures and contributions to the crisis over the last 20 years, it is bizarre to see the Federal Reserve being given increased responsibility. It is not clear how we will inspire an "extreme makeover" of regulatory incentives inside an institution more responsive to banks than to people that has clearly failed in the eyes of the American public.

    The problem now for progressive voters is not dissimilar to the situation they faced on health care. Real reform will not be produced by the White House and Congress, both controlled by the Democratic Party. Failure to pass any bill would likely lead to cries across the country that the Democrats, with both the presidency and substantial majorities in both houses of Congress and the White House, are in the pocket of Wall Street and should suffer at the voting booth. Cosmetic reform will perhaps avoid the criticism that Democrats are unable to govern, but it will not address the true structural issues and will leave the prospect of an even more violent crowding out of social expenditure after the next round of bailouts.

    With the pressure to support what Ralph Nader called the "least worst" party, will progressives join the dance and pretend they have real consumer financial protection? Will they delude themselves into believing that the proposed legislation would end "too big to fail" and the risk of future taxpayer bailouts? Or will they refuse to be party to rituals of false remedy and see that crony financial bailouts and episodes like the failure of Lehman Brothers and the bailouts of American International Group, Bear Stearns, and Citigroup could all happen under this new legislation much as they did before? We deserve better, and it is not too late to demand it.