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RE: Do we really have a clue what financial reform we need?
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John Gelles
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Oct 28, 2009 15:32 PST
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This subject and message was received by email -- but it failed to be
printed in the WEB version of this forum.
So let me try to correct this screw-up:
[Copyrighted text is recopied here on a not-for-profit
educational-activist site, at the teachable moment, in conformance with
applicable law. The material to be debated here in later posts was
released to the public without charge by the copyright owner. This
additional release of the material will further its chance to be read
and attributed to Cooley and FORBES. It is fair use of the material.]
FORBES ON THE INTERNET:
Capital
Fiddling Over Reform
Thomas F. Cooley, 10.28.09, 12:00 AM EDT
Paul Volcker and Mervyn King are slapped down.
For the past year, former Federal Reserve Chairman Paul Volcker--head of
the president's external advisory committee on financial reform--has
been thinking carefully about the roots of the financial crisis. He has
reflected on a regulatory structure, the Banking Act of 1933, frequently
referred to as the Glass-Steagall Act, that worked pretty well for
several decades until it was undermined by innovation and the lobbying
efforts of financial market participants. The conclusion he has reached
is that the best way to regulate the financial system going forward is
to go backward to a framework mandated by Glass-Steagall that isolates
commercial banking from investment banking and other risky activities.
The only viable solution, in the Volcker view, is to break up the
giants. JPMorgan Chase would have to give up the trading operations
acquired from Bear Stearns. Bank of America and Merrill Lynch would go
back to being separate companies. Goldman Sachs could no longer be a
bank holding company. It would be a major restructuring.
Article Controls
Going back to a simple structure that worked is an appealing idea.
Although I don't think it is the best solution to the problem of
regulatory reform, for reasons that I will detail below, it isn't
completely crazy. Many others have come to same conclusion. Mervyn King,
the Governor of the Bank of England, suggested last week that separating
core aspects of banking from riskier activities could reduce the chance
that a bank failure could put the whole financial system at risk. He
also said that banks should not be allowed to become "too important to
fail," a view held by many--even those who don't think a modern
Glass-Steagall is the answer.
Nevertheless, Volcker was rebuffed publicly by the administration he
serves and King was openly ridiculed by Gordon Brown and Alistair
Darling for proposing to break up the banks. Both the U.S. and the U.K.
are embarked on other approaches to regulation.
Much of the ensuing discussion in the media and among policymakers was
completely puzzling and seems to have missed the point entirely. Many
were quick to point out that separating commercial and investment
banking doesn't prevent failure. Gordon Brown said: "Northern Rock was
effectively a retail bank and it collapsed. Lehman was effectively an
investment bank without a retail bank and it collapsed. So the
difference between having a retail and investment bank is not the cause
of the problem."
Preventing failure was never the issue to be solved. Making failure
possible and less threatening to the whole financial system was and is
the problem. The very notion that some institutions are too big or too
complex to fail is at the heart of the issue, and paradoxically
everything that has happened in the months since the financial crisis
began has encouraged the remaining institutions to become larger, more
complex and more systemically risky.
Another argument against the separation of commercial and investment
banking raised in both the U.K. and the U.S. is that if we break them
up, they won't be able to compete effectively against Universal Banks
and business will flow elsewhere. This argument is patently absurd.
First, there is little or no evidence that the large complex financial
institutions manage their businesses more effectively and plenty of
evidence that the very complexity of their enterprises can distract them
from managing important, profitable lines of business well. Citigroup's
mismanaged credit card franchise is a good example. And there is ample
evidence, as my Stern School colleague Ingo Walter points out, that the
large complex banks could not manage their internal conflicts of
interest and were immersed in numerous scandals that pitted the
interests of clients and their investment banks against investors in
their mutual funds and other parts of their operations. He also points
out correctly that over the decades in which investment banking was
separated from commercial banking by law, U.S. investment banks
flourished and became the model for the rest of the world.
My argument against a return to Glass-Steagall-like restrictions is that
it tackles the wrong problem. The real issue is that some institutions
expose the entire financial system to risk by decisions taken within a
single firm or business unit. That is what systemic risk is--it pollutes
the financial commons. Making financial institutions smaller or simpler
doesn't really address systemic risk. It may make it easier to identify,
but it doesn't fix the problem.
Unfortunately, the alternatives being discussed in Washington and by the
Obama administration don't address the issue very directly either, but
there are signs of progress. One encouraging sign is that Fed Chairman
Ben Bernanke has come out in favor of a resolution authority, much like
that of the FDIC for insolvent systemic institutions. That is a critical
component of meaningful financial reform. It is reported that the
Treasury and the House Financial Services Committee are drafting
procedures that would let them wipe out shareholders, change management,
and restructure the debt of large insolvent institutions.
A very hopeful sign is that they are discussing the "polluter pays"
principle that I have been writing about for over a year as the way to
think about systemic risk. On this view, the way to discourage the
accumulation of systemic risk is to measure it, price it and make firms
pay for creating it. This, in the long run, offers the most hope for
discouraging reckless behavior. More importantly, in the long run, it
should help to discourage firms from becoming so large and complex that
they cannot monitor it themselves.
The statements emerging from the House Financial Services Committee make
it unclear that they really embrace the idea that the polluter should
pay. Equally, it is unclear that the Administration is fully willing to
embrace the idea that firms cannot be too big to fail and that such
unpriced guarantees create more risk and bad decision making. But this
is the critical time and this is the critical debate to be having. If we
don't tackle it, we can sit back and wait for the next meltdown.
============= end article in FORBES =============
Thomas F. Cooley, the Paganelli-Bull professor of economics and Richard
R. West dean of the NYU Stern School of Business, writes a weekly column
for Forbes. He is a contributor to a Stern School book on the financial
crisis, Restoring Financial Stability (Wiley, 2009).
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Gelles comments on the above are in the next reply.
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