Boring is Best in Financial Reform
The most famous story of Wall Street is of an out-of-town visitor brought to Lower Manhattan and shown the dazzling boats of the bankers and brokers. “But where are the customers’ yachts?” the visitor inquires. The perception of Wall Street as the embodiment of rapacious waste continues to haunt the American psyche. Amidst the deepest recession since World War II, politicians from Andrew Cuomo to Ron Paul have found finance an easy target; yet their sharp critiques have gone mostly unheeded. While President Obama speaks of the need to reform the financial sector, Democratic legislation does not suggest drastic changes. Nonetheless, many of the proposed reforms will still prove ineffective or implausible, meaning true financial reform will rely upon boring, yet effective, capital requirements.
A Revised History of the Crisis
Even before the United States emerged from the 2008 credit crunch, popular perception already attributed much of the blame to the unregulated financial sector. This narrative is simple, succinct, and misleading. As the Heritage Foundation’s David John told the HPR, “There is no simple answer that includes a significant portion of the 2008 crisis.” John described factors from massive foreign surpluses of investment capital, to homeowners expecting endless double-digit returns as far more integral to the credit crunch than any government policy.
Some experts nonetheless contend that regulatory failure exacerbated the downturn. Speaking to the HPR, Doug Elliott of the Brookings Institution claimed that, “The government did make some serious mistakes…and better regulation would have reduced the level of damage.” As Elliot explained, commercial banks had long been limited to borrowing up to 16 times their capital, and investment banks somewhat more. Yet in 2004, the Securities and Exchange Commission permitted investment banks to leverage up to 40 times their asset base. Meanwhile, commercial banks discovered new ways to leverage, notably with Structured Investment Vehicles. The effect was to make banks both more profitable and more exposed to a downturn; a three percent loss, for instance, bankrupts a 40 times leveraged position. Yet short of banning SIVs altogether, regulating them would have proven difficult because their existence relied on being outside the regulatory structure. Elliott thus sees leveraging and SIVs as symptoms of a fundamental problem, arguing, “We had twenty good years in the markets. Individuals and investors learned that risk wasn’t scary and that taking risks was a lucrative thing to do. … The problem was that people assumed that it would continue forever.”
Taming the Finance Beast
In hopes of dampening the next era of complacency, the White House has called for the creation of a Consumer Financial Protection Agency designed to prohibit certain financial products, such as subprime loan prepayments. Proponents like Harvard Law Professor Elizabeth Warren argue that the CFPA would benefit financial institutions and consumers by limiting the mortgages and material with which Wall Street self-destructed. Yet George Mason Law Professor Todd Ziwiki disagrees, telling the HPR that, “Consumer protection did not cause the [2008] crisis and it won’t stop the next crisis.” Even if consumer protection does not equate to financial protection, however, it has occupied a significant fraction of congressional action on the issue. David John attributed this incongruity to the fact that, “Congress as a mechanism reacts to pressure from constituents. Constituents don’t understand capital requirements, but focus on the fact that they signed something, and something unpleasant happened.” Thus, additional mortgage disclosure requirements substitute for substantive financial regulations.
Washington’s responses to the crisis beyond the CFPA are an equally mixed bag. Most prominently, Federal Reserve Chairman Ben Bernanke has argued for a “super-regulator” over the financial sector to end the practice of multiple agencies imposing differing regulations on the same jurisdiction. Bob Litan of the Kauffman Foundation, an organization promoting entrepreneurship, explained to the HPR that, “Before, financial institutions were able to play one agency off of each other. AIG, for example, went to the Office of Thrift Supervision, and was able to go berserk.” The super-regulator would end the practice of ‘regulatory shopping,’ searching for the most lax regulator. Bernanke’s proposal has nonetheless drawn opposition, not least from the heads of the current regulatory agencies, who fear a diminution of their power. As Litan put it, “The CFPA is a backlash against the Fed and a super-regulator.”
More acceptable to all stakeholders may be House Banking Committee Chairman Barney Frank’s proposal for a systematic risk regulator to monitor general levels of risk in the economy. Litan agrees that, “It can’t hurt to have a systemic risk monitor, someone to warn people that there are bubbles being formed. …I prefer adjustment in loan to value ratios when you see bubbles being formed, but I worry you could have a regulator criticized for taking away the punch bowl at the party.”
Party’s Over
Indeed, Litan’s worry that investors will scorn regulation that curtails markets reflects larger concerns about the political implications of reform. It would have been an unpopular bureaucrat who proposed to halt the rising tide of the housing market in 2005, and the calls would likely have gone unheeded. Moreover, even if regulators have the will to sanction, they might lack the ability to distinguish. As Ziwiki pointed out, Washington has a poor history of regulating financial firms; according to him, “The SEC doesn’t work is because its regulators get captured.” In other words, the competent regulators get hired to work for the industries they were regulating, while the second-tier people remain behind.
Thus the most effective reforms may paradoxically be the easiest to apply. Increasing capital requirements may seem far less innovative than overseeing all levels of risk in the economy, yet the simplicity of the measure is its greatest appeal. More capital might not have saved insolvent firms, but it would certainly have nudged them toward fewer risks. Indeed, as John pointed out, “It makes perfect sense to try to deal with too-big-to-fail [companies] through capital standards,” thereby sidestepping questions of regulating the complex securities that neither regulators nor bank CEOs truly grasp. In Litan’s words, “I feel that the market does a reasonable job when you give it the right incentive, and capital requirements are a good signal.”
Wall Street and Washington have long been intertwined, dating back to at least 1912. Again and again, financial crisis has prompted new and diverse approaches to regulation, yet America is no closer now to ending boom and bust than when the regulatory climate first shifted. Because many of the administration’s current regulation proposals will ultimately prove ineffective or politically infeasible, increasing capital requirements may be the best option of a bad lot. This simple regulation won’t guarantee the customers their own yachts, but perhaps capital requirements may still save their 401(k)’s.
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