President Obama's Financial Reform Package-Becker

Since the document laying out the President's financial reform package is 88 pages, I will concentrate my evaluation on a few basic issues. 1) Do the reforms rely mainly on regulatory discretion or on new rules? 2) Is there adequate attention to the issues raised by financial institutions being "too big to fail"? 3) Is it proposed to micromanage the operations of financial institutions and individuals? 4) Most important, are these reforms likely to greatly reduce the likelihood of another financial meltdown? I take them up in turn, but my overall grade for the plan is no higher than a B-, and perhaps as low as a C. During this crisis, regulators of banks and other financial institutions generally did not use the authority they already had to rein in the asset expansion and various excesses of commercial banks and other financial institutions. This is not at all surprising since regulators usually get caught up in the same "exuberance" as bankers, and no more see the looming risks to the system and to individual banks than do bank executives. Moreover, examples from many industries show that regulators frequently get "captured" by regulated firms, and tend to support the interests of these firms. This occurs even when the actions of firms are contrary to the public interests, and when regulated firms do not bribe or exercise other improper influence on regulators. For these reasons, any new regulations should mainly operate automatically through rules rather than relying on discretionary decisions of regulators. Unfortunately, although the plan does contain new rules, they rely too much on discretionary choices of regulators. For example, the plan advocates creating a mechanism that allows regulators to take over large, failing financial firms, and to decide how to fix them, but it does not specify how the regulators should fix banks, or even when they should take them over. The plan encourages the Fed to monitor systemic financial risk, but it does not indicate how the Fed should determine whether systemic risks are excessive. My overall grade on the place of rules vs. discretion in the proposed changes would be no higher than a B-. Countries tend to bailout large firms more often they should, including large and/or highly interrelated banks and other financial institutions. Nevertheless, big and complex financial institutions that appear to be failing will often be bailed out in the future, especially in light of the perception that the failure of Lehman Brothers triggered a sharp worsening of the crisis, and a dramatic retreat from risk. In order to reduce the likelihood of the need for such bailouts, large banks should be required to have especially high capital requirements (see my post on March 9). Perhaps they should also be forced to have much of their capital in liquid forms. The President does propose that the Fed should more heavily regulate and supervise large financial firms- possibly including special capital requirements- but the proposals appear to give the Fed much more discretion than is desirable. Overall, the grade on the too big to fail proposals is a B or B+. Abundant evidence from the US experience and that of other countries indicates that governments do badly when they attempt to micromanage firms and individuals in the financial and other sectors. Nevertheless, the government proposes to have regulators issue guidelines on executive pay, with the intent of "better" aligning pay with stockholder value. It also wants to "better" relate the compensation of financial firms to the long-term performance of their loans, and to require non-binding shareholder votes on executive compensation. Another proposal would prevent "unsophisticated" individuals from trading derivatives "inappropriately". Others would ban or restrict mandatory arbitration clauses, and would regulate bank overdraft provisions. Still other parts of the plan would mandate that some employers offer automatic IRA plans to employees, and the government proposes to regulate closely the investment choices made by holders of these plans. The degree of micromanagement of company and individual behavior in these and other provisions is distressingly high (see our posts on the case against controls over executive pay on June 14th). This is why the overall grade on the proposed degree of micromanagement of financial institutions and individual behavior is no higher than a C. Would the changes embodied in President Obama's financial plan greatly reduce the likelihood of another major financial crisis? An honest answer is that no one really knows because it is not yet clear which of the myriad aspects of the American financial system were the most important causes of the crisis. For example, some discussions blame the generous compensation packages provided to executives of banks and funds, especially the close dependence of total executive compensation on current profits and the value of their stock holdings. However, Japan had a terrible financial and economy wide crisis throughout the 1990s, even though Japanese executives are paid much less than their American counterparts, and Japanese executive pay is much less dependent on profits and stock prices. Others have claimed consumer ignorance is responsible for the sharp growth in subprime and other mortgages, and for the great expansion of credit card debt. Yet who could blame poorer families for buying homes when they received great deals in the form of low interest rates-partly due to the Fed's policies! - and very low down payment requirements. Low down payments and low interest rates might have been mistakes of the lenders, and of government policy that encouraged such loans, but they hardly indicate that consumers were fooled into taking out these mortgage loans. Similarly, lower income consumers like to borrow on their credit cards because that debt is often the cheapest and most flexible form of credit available to them. Small print on credit card contracts and fast-talking mortgage salesmen were just not important forces in determining what happened in mortgage and other consumer credit markets. A basic problem is that when little is known about the likely effects of new financial regulations, they are more likely to harm rather than help the financial system. Suppose, for example, that regulation of pay of financial executives appears to have a 1/2 chance of improving the efficiency of the financial sector by 25%, and a 1/2 chance of reducing efficiency by the same 25%. The average expected impact of such pay regulation on efficiency would be zero, but it would increase risk by raising the expected variance in the efficiency of outcomes. Therefore, when there is sizable ignorance about the consequences of new regulations, governments should only introduce those financial reforms that are much more likely to improve rather than worsen the performance of the financial sector. When the government's financial proposals are evaluated from the medical principle of "do no harm", they cannot be given better than a C grade. The lesson from this low grade is not to stop reforming the financial sector, but to go slowly, and introduce now only those changes that seem quite likely to reduce the prospects of another crisis. For example, higher capital requirements, especially for larger banks, seem to be justified even though the precise role in the crisis of high and growing leverage of bank assets is not clear. Similarly, central counterparty exchanges for derivatives are often desirable, although the benefits are likely to be greater if traders are induced to participate in these exchanges rather than mandated to do so. The case for other changes in financial markets may also be strong. However, most of the proposals in the President's plan should be put on hold until much more is learned about the causes and possible cures for this and future financial crises.

Comments

[Anonymous]

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Shox 2:45

[Anonymous]

great~~~~
it took me a long time to read all of this ,
i'm not good at english ,it's really hard for me .

i'll keep focusing my attention on your blog.

[Anonymous]

This is a tough situation to try and regulate beforehand. We're trying to predict human nature as it relates to greed, and that's not an easy thing to do. Repealing the Glass-Steagall Act was the first in a long line of dumb decisions that were made.

[Anonymous]

When I went to the GSB twenty years ago, a C was a pretty good grade

[Anonymous]

A good and long article. This will help more people to know the finanical reform.

[Anonymous]

I wouldn't give the plan better than a D. Punts on Fannie/Freddie - which will end up costing close to $300 billion, and who fueled the growth of the subprime market. Plan does nothing to address massive subsidies toward corporate and individual leverage in our tax code, nor addresses subsides for homeowership. Plan broadens bailout safety net to more institutions w/o any real increase in regulation - bank regulators can already raise capitol. And of course, plan lets misguided monetary policy off the hook.

[Anonymous]

This country is getting what is deserves. The people running this country right now are going to destroy it. I have zero respect for any of them. I would never let any of my kids fight for this country anymore. I no longer have an ounce of patriotism, actually ashamed of my country. I honestly think this whole thing has to implode before we ever get back to our founding principles.

This is the coldest calendar year in decades, and we are about to tax carbon...? The northeast hasn't even seen the sun yet and our democrats are setting up the largest ponzi scheme ever with Cap and Tax under the guise of man-made global warming.

Obama says bankruptcy is not an option for Detroit one day. The next day he organizes a bankruptcy at Chrysler, screws a teacher's retirement fund, and props up his union buddies. And republicans hate teachers...!

Sotomayor headed to a Court that just rejected her racism. Just another Ginsburg bleeding heart marxist. We need reparations for hispanics now because they can't learn our language and pass fire fighter exams.

When conservatives stop defending this country, it is all going to fall apart because nobody else will. The lessons of Rome all over again. Better fill your pockets anyway you can, might have to cozy up to those boasting about fraudulent energy sources.

DON'T TREAD ON ME...!

[Anonymous]

I forgot to add...

Barney Frank is proposing a new way for the GSE's to lend to those who can't pay a mortgage. Repeat of the 1990's I guess...! I guess they just have to force the banks to lend all over again.

It is okay though. We'll just blame the next republican president when this house of cards pops. We'll just reinflate the housing bubble all over again with BS like $8000 credits for first time buyers and artificially low interest rates. We'll forget all about Barney's ideas again, afterall GOVERNMENT IS NEVER THE PROBLEM.

[Anonymous]

You argue that individuals were acting in their perceived short term best interest when they took out inappropriate loans or excessive credit card debit. The crash has demonstrated that these actions, perhaps personally optimal in the short term, were neither societally nor personally optimal in the long term. And yet you still argue against regulations intended to prevent other individuals from making the same mistakes. Why?

[Anonymous]

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[Anonymous]

"And yet you still argue against regulations intended to prevent other individuals from making the same mistakes. Why?"

Nobody is arguing against proper regulation. The repeal of Glass Steagle was a mistake made by the Clinton Administration. I am arguing that beyond this government interference with the market causes bubbles and the inevitable bursting of those bubbles.

Great article from 1999.

http://www.nytimes.com/1999/09/30/business/fannie-mae-eases-credit-to-aid-mortgage-lending.html

We know the government sponsored subprime lending and allowed the GSE's to get too big on an "implicit" guarantee. Government allowed this bubble to form in the market. Bill Clinton actually started this mess (with the repeal of Steagle combined with pushing GSE's and subprime lending) and Barney Frank obstructed the Bush administration from reform in 2003.

Barney Frank is putting the ball in motion to do it all over again. This is like the sequel to Rocky XXXV all over again, except this time Rocky is a gay fat freak who cannot speak english just like Barney.

[Anonymous]

http://en.wikipedia.org/wiki/Gadsden_flag

To illustrate your objection to the idiots running this country into the ground, don't fly Old Glory this July 4th. Try one of these flags instead.

Liberals burn flags to protest. Conservatives just pick flags that represent their principles. Maybe we'll go back to Old Glory once the socialists are voted out, but the damage they do may be irreversible unfortunately.

[Anonymous]

Taxing carbon when the unemployment rate is 10% is the dumbest idea ever proposed by a politician.

Obama and the Dems in Congress are destroying this country.

[Anonymous]

I think that the fundamental cause of this crisis on the side of the consumer is that people agreed to take part in contracts which they did not understand. The two biggest examples are adjustable-rate mortgages, which clearly contributed to the crisis when they began to default, and Bernie Madoff's Ponzi Scheme (which had precious little if anything to do with the economic crisis).

All I mean to say is that people shouldn't sign contracts they cannot understand.

With this in mind, I think that the moral hazards created by government intervention and guarantees in the financial sector gut the incentive for people to actually learn this lesson.

[Anonymous]

Obama is best President

[Anonymous]

very nice and informative article

[Anonymous]

Hey!

Your blog isn't asking me for permission to use my URL!

Can you please fix it?

http://www.reddit.com/r/news/comments/8xsgg/those_who_wish_to_keep_the_internet_free_and_open/

[Anonymous]

The current financial crisis was in many ways driven by the Federal Reserve and their inappropriate and emergency actions to lower the interest rates, leaving nothing in the tool box to counter the slow down in the economic.

For a long time Federal Reserve Chairman was holding the interest rate steady.

The country was experiencing a severe recession, though listening to WBBM (780 on the dial) radio at noontime being in denial of the fact by arguing over a definition of a recession, despite those who would come on the radio program indicating the economy was collapsing, which the two moderators would dismiss out of hand.

The two radio hosts were no more than readers versus any careful analysis of the economic trends. Nothing has change there. You can get ten year olds to do a better job of good and sound reporting and interviews than these two idiots of irrelevancy.

I had sent the Chairman numerous E-Mails, indicating the lowering the interest rate would wreck havoc on the economy looking toward a total collapse, receiving nice thank yous, indicating that chairman taking all things into account.

At one point with the stock market constantly down on a daily basis, I went to the Plant Manager of Horsehead Corp of Calumet Plant that he should seriously think about how he would run the plant with a total collapse of the economy. He smiled and somewhat laughed at my sincere comment that such thing cannot happen.

The current administration under President Obama has taken steps to begin to fix the problem by addressing the seriousness of the mess left by President Bush, who try to wreck the entire country, violating the Oat of Office.

Previous actions certainly didn’t advert what occurred, sleeping at the helm and curtailing whistle blowers.

The Republicans who have create the mess have become obstacle in its proper fix, lending themselves to un American activities through their actions and deeds instead trying to cooperate to bring change than continuing status quo, the good of the party versus the Good of the Country.

Thatguy

[Anonymous]

thanks
بنت الزلفي

[Anonymous]

I've got a novel idea. Let shareholders and creditors in failing institutions get wiped out. That should incentivize more conservative management since the funding of risky institutions would be dramatically greater. It is hard to make the quick buck if you can't get the capital to do so. The more conservative banks would have made a killing with the failure of the 'weak' banks and the government could have provided those institutions with the liquidity the market needed.

As for consumers, they knew exactly what they were doing. Everyone was expecting continuing home price appreciation which allowed them to justify putting little to no money down, exaggerate their income, and not consider the consequences of taking out a loan with a short-term 'teaser' rate. I wonder if the risk appetite would be different if mortgage loans were recourse.

Or maybe people are right and consumers were uneducated dolts that didn't have the capacity to understand the risks even if they wanted. That completely justifies moving to a state in which the all-knowing government makes our decisions for us (i.e. communism).

[Anonymous]

Thanks for the very enlightening article

[Anonymous]

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[Anonymous]

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[Anonymous]

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