Is the President finally getting serious about real financial
reform? Last Thursday, Obama called for the biggest regulatory
crackdown on banks since the 1930s, proposing strict limits on the
size of financial institutions and a ban on risky activities such
as proprietary trading and internal hedge funds. If enacted by
Congress, Mr. Obama's proposals could force Wall Street names like
JPMorgan Chase (
) and Goldman Sachs (
) to spin off their huge hedge fund and private equity operations
and stop making trading bets with their own money. New, unspecified
limits on liabilities would go beyond an existing rule restricting
banks to holding no more than 10 per cent of US deposits and
prevent an investment banking-focused institution from growing so
large as to pose a systemic risk.
These proposals represent a vast improvement over what has been
hitherto proposed, but they do not go far enough. At this stage,
the primary focus seems to be on banks. But it is worth recalling
that an unregulated insurance company, [[AIG]], was at the
epicenter of the securitized mess that represents our current
financial system. This fact alone suggests that a more broadly
based approach, which incorporates any financial services
intermediary, might ultimately be required.
A straightforward restoration of something like the New Deal era
Glass-Steagall Act's complete separation of investment and
commercial banking activities would neither eliminate the problem
of Wall Street firms that are "too big to fail", nor would it
address the underlying practices which created systemic risk in the
first place, largely because securitization has blurred the
distinction between commercial and investment banking.
Additionally, a revived Glass Steagall Act just gets us back to
1999, when banks were becoming irrelevant, with only 20% of total
assets. The demise of Bear Stearns and Lehman Brothers (LEHMQ.PK)
shows that unsustainable bank-funded asset price booms can and do
occur among smaller banks and even non-bank financial entities such
as GMAC. In that regard, lower capital requirements coupled with
greater restrictions on securitization, as opposed to higher
capital requirements and fewer restrictions on securitization, is a
better focus for the proposed legislation.
Ultimately, it is necessary to recognize that the liability side
of the balance sheet is not the correct area to enforce proper
regulation of the banking sector. The primary focus of bank reform
should be on regulating the asset side of the balance sheet. This
is particularly important, inasmuch as the FDIC has effectively
guaranteed the main liabilities--the deposits. With that in mind,
many activities of the banks need to be banned, taxed and/or
To begin with, the $250,000 deposit ceiling should be removed
altogether. The quid pro quo for the provision of this service by
the FDIC would be restrictions on the activities of banks, so as to
minimize systemic risk. With banks funded without limit by
government-insured deposits and loans from the central bank,
discipline should remain entirely on the asset side. Such
discipline necessarily includes limiting banks to assets deemed
'legal' by the regulators and restrictions on off-balance sheet
Simply enforcing higher capital ratios is insufficient, because
they functionally act like a tax. Higher capital ratios restrict
the banks' ability to lend, and thereby raise the returns demanded
from the borrower. All they do is raise the common cost of funds
for banks, which effectively is passed on to the consumer,
contradicting the policy of current Federal Reserve policy to lower
rates. Furthermore, higher capital ratios can also be easily gamed
via accounting scams, which are usually ratified after the fact by
our regulatory bodies (Basel II is a perfect illustration of this
Banks are set up and supported by government for the benefit of
the economy in order to provide a payments system and lending in a
way that is specifically defined by regulators. Consequently, banks
should be prohibited from engaging in any secondary market activity
because it serves no public purpose and may result in severe social
costs in the case of regulatory and supervisory lapses. Banks
should only be allowed to lend directly to borrowers and then
service and keep those loans on their own balance sheets.
The other key component to ensure real financial reform is to
establish markets that are liquid and deep. This means relying on a
large number of smaller institutions carrying on traditional
banking activities, rather than having these activities
concentrated in the hands of limited number of highly capitalized
The former creates vibrant competition and a more stable banking
system with less systemic risk, whilst the latter is
anti-competitive and even more prone to systemic risk, given the
large concentration of deposits in the hands of a minimal number of
banks today, along with their insistence to perpetuate highly
destabilizing activities contrary to public purpose.
In regard to proprietary trading, hedge funds, private equity
operations, and other pools of unregulated funds should be allowed
to continue to operate. But they should be allowed to fail when
their bets go bad. What the vast majority of Americans need is a
protected and closely regulated portion of the financial sector for
those who do not want to take excessive risks, as L. Randall Wray
. And any institution that bets with "house money" - that is, that
has access to the Fed in the case of a liquidity problem and to the
Treasury in the case of insolvency must be constrained. That is the
direction that true reform ought to take.
The top four banks (BofA (
), Citi (
), JPMorgan-Chase, and Wells Fargo (
)) hold about half of the country's deposit base. Failing to
restrict their range of activities not only encourages each to "bet
the bank" through excessively risky trades. It also tells all other
financial institutions that their only hope is to join the "too big
to fail" club through unsustainable growth that requires they adopt
the same failing strategies adopted by the behemoths.
By the same token, if a bank instead relies on credit default
insurance, then it is transferring that pricing of risk to a third
party, which is counter to the public purpose of the current
public/private banking system. Consequently, banks should not be
allowed to buy (or sell) credit default insurance. The public
purpose of banking as a public/private partnership is to allow the
private sector to price risk, rather than have the public sector
pricing risk through publicly owned banks. If the public sector
wants to venture out of banking for some presumed public purpose it
can be done through other outlets.
"Hold to maturity" is a good starting point for the deposit
taking institutions. To be sure, an inevitable byproduct of
restricting securitization or proprietary trading is that they can
and will reduce a bank's profitability. But such regulation keeps
them aligned with public purpose - namely, providing an ongoing,
stable basis for lending, independent of market conditions - while
avoiding the incentive for banks to game the higher capital
requirements via questionable accounting scams.
Is it realistic to ban securitization outright? Recognizing that
securitization is so firmly embedded in our capital markets
structure, there may well be practical limitations to a "hold to
maturity" standard for all financial institutions. But something
must be done to mitigate the risks associated with
In its earlier incarnation securitization undoubtedly
facilitated the expansion of lending to smaller businesses.
However, the more recent proliferation of Frankenstein style
products, such as "collateralized debt obligations" or
"collateralized loan obligations" has increased risk enormously,
and misallocated it, without providing long-run advantages.
When a commercial bank makes a loan, the loan officer wonders
"how will I get repaid?" Because the loan is illiquid and will be
held to maturity, it is the ability to repay that matters-and it is
most prudent to rely on income flows rather than potential seizure
and forced sale of the asset at some time in the possibly distant
future and in unknown market conditions. On the other hand, when an
investment bank makes a securitized loan, the loan officer wonders
"how will I sell this asset?"
In the words of
Professors L. Randall Wray and Eric Tymoigne
The future matters only to the degree that it enters the value
of the asset today because it will be sold immediately. Even the
buyer of the asset need not worry about the distant future
because the liquid asset can be unloaded quickly. Especially when
confidence is high and euphoria reigns, it is easy to sell assets
whose value is disproportionately determined by expected asset
appreciation (and goodwill). The sky is the only limit to how
much an asset's value might rise, hence no euphoric expectation
can be easily dismissed. And any debt ratio can be justified as
sound because it will automatically fall as the asset
This is the downside to securitization.
To mitigate this impact, there is no reason why Congress could not
rescind SEC rule 3a-7. This rule exempted securitized structures -
the main elements of the so-called shadow banking system - from
registration and regulation under the Investment Companies Act.
This rescission would functionally act like a Tobin tax, insofar as
the resultantly higher regulatory thresholds would significantly
slowdown the proliferation of securitized financial products. In
addition, by imposing a fiduciary responsibility on the issuer,
Congress would ensure that the issuer retains "skin in the game"
and thereby encourages more responsible lending behavior.
Taxing activities contrary to public purpose is another possible
approach. In recent speeches, President Obama has discussed taxing
certain banking activities, although the size of the tax he has
proposed is too small. Moreover, the rationale for the tax is not,
as the President recently suggested, "to get our money back".
Rather it should be imposed to prevent a recurrence of the problem.
The profits of the banks are running at around $90 billion a year.
They probably pay out close to half this much in bonuses. A $120bn
tax over 10 years represents a mere 6 percent of the banks'
profit/bonus mix. Perhaps not trivial, but their after tax earnings
would still represent a much larger share percentage of total
profits to GDP than they did 10 years ago, even with the proposed
Ultimately, the test should be the following: Is the tax set at a
sufficiently high threshold to render the activity in question
uneconomic or, at the very least, does it substantially slow down
its growth? Revenue raising per se is a secondary consideration.
True, the kind of tax we are proposing would be punitive, but in
the same manner in which a cigarette tax is punitive. When we tax
cigarettes, we do it to discourage fundamentally unhealthy
behavior, not because we want to raise tax revenue.
The current tax levels hitherto outlined by the President are
insufficient to achieve this purpose. Here is what should be done:
The tax rate should increase with asset size, rather than being a
flat rate. Exempt small regional banks with under $25 billion in
deposits. Make the tax progressive so it becomes increasingly
larger as deposits become greater. $25-$50 billion in deposits is
one fee (Let's say 0.1%, that's $25 million on $25 billion in
assets). Have it scaled to the point at which it becomes punitive.
1% annually on a trillion dollars in deposits will likely prove
sufficient to deter activities contrary to public purpose.
Phase in the taxes slowly over a few years, as Congressman Barney
Frank has suggested, to give existing firms time to arrange
efficient de-conglomerations. Importantly, legislators should
characterize the target market structure, and empower regulators to
define and alter tax schedules as necessary to achieve that target,
rather than specifying them in law, to counter gaming by nimble
These necessary reforms of the U.S. banking sector need not be
delayed by the actions or non-actions of America's international
partners. Although U.S. authorities often like to pretend that
their hands are tied by other regulators, in fact the U.S. holds a
trump card in this situation: It can ban the banks of any country
that does not regulate its banks seriously from doing business
here. There are thousands of smaller American banks that will be
happy to fill the void, and likely do the job far better.
The major consequence of thirty years of financial deregulation is
that it has rewarded destructive competition rather than
constructive competition. Indeed, it rewards those who maintained
and grew their market shares by any means without any consideration
for others (especially the financial well-being of borrowers), and
it punishes financiers who refused to resort to unprofessional
underwriting practices even if it meant a drastic reduction of
their market share. The time has come to construct regulation which
rewards the latter (usually small financial institutions) and
punishes the former.
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