The Financial Regulation Law—Posner’s Comment

I agree with Becker’s criticisms of the new law (not quite a law yet—it has not been passed by the Senate, but I am guessing it will be, because an ignorant public demands action). It’s a monstrosity, and a gratuitous one, as there is no urgency about legislating financial regulatory reform. The financial regulatory agencies have ample, indeed essentially plenary, authority over the financial industry; and because they were asleep at the switch when disaster struck, they are now hyper-alert to prevent a repetition of it. Indeed, bank examiners have become so fearful of condoning risky banking practices that they are making it difficult for banks to lend to small businesses and consumers and thus are retarding the economic recovery.

 

The principal factors in the financial and larger economic collapse appear to have been : (1) Incompetent monetary policy under Alan Greenspan and his successor Ben Bernanke, which enabled the housing bubble. The bubble’s bursting brought down the financial industry, which was heavily invested in both residential and commercial real estate. (2) The inattention of the Federal Reserve and the Securities and Exchange Commission, which did not understand the changing nature of the banking industry, particularly the rise of “nonbank banks” dependent on short-term, uninsured capital. Solvency regulation of these banks was overly lax. (3) The overindebtedness of the American people and government, which has hampered the restoration of credit. And (4) the failure of the Treasury Department under Henry Paulson, and the Federal Reserve under Bernanke, to rescue Lehman Brothers; they didn’t realize that Lehman’s bankruptcy would trigger a run on the banking industry, causing a global credit freeze.

 

Obama’s principal economic officials—Bernanke, Timothy Geithner, and Lawrence Summers—were implicated in the regulatory oversights that precipitated the crisis, as were key legislative officials, such as Christopher Dodd and Barney Frank. None of them wants to shoulder blame for the crisis. They want to change the subject. So instead of blaming government, they blame the banking industry. The industry did take risks that were excessive from an overall social standpoint, but industry will always take the risks that government permits them to take, if the risk taking is highly profitable and losses if the risks materialize will fall mainly on others, which is what happened. Some banks took a hit, but the big ones are doing well. The government saved them from bankruptcy and has allowed them to borrow from the Federal Reserve at interest rates close to zero, thus enabling them to return to profitability without doing much lending, which banks are reluctant to do during a deep economic downturn, when default risk soars.

 

But for government officials to say "we blew it—we had the powers we needed to prevent the crash but failed to use them because we were complacent and inattentive" would not be a politically satisfactory response to the economic debacle. Just as politics requires that the President be seen to “do something” about the oil leak in the Gulf of Mexico, though there is nothing he can do, so politics requires that Congress “do something” to prevent a repetition of the economic disaster, though there is nothing it needs to do.

 

Much that the 2300 page long “Dodd-Frank Wall Street Reform and Consumer Protection Act” ordains is within the existing powers of the financial regulatory agencies to effectuate. For example, although the Act creates a Financial Stability Oversight Council (consisting mainly of the chairman of the Fed, the Secretary of the Treasury, and the chairmen of the Federal Deposit Insurance Corporation and the SEC) to advise the President and Congress on systemic risk, these officials don’t need legislation to hold regular meetings if that would be useful. The reason for creating such a Council is purely political: a governmental reorganization is a favorite response to a governmental failure because it is visible, easy to explain, usually cheap (it involves mainly just moving the boxes in a table of organization), and can be designed in such a way as to avoid ruffling too many interest-group and government-bureaucracy feathers. It also buys time, since no one expects a reorganization to be effective immediately.

 

In like vein the Act in several hundred pages directs the creation of a consumer protection bureau to be lodged in the Federal Reserve Board. The Fed already has such a bureau; it is ineffectual because the Fed cares about the solvency of banks, not the solvency of their customers. Congress proposes to correct this skew by making the head of the Fed’s consumer protection bureau (renamed the Consumer Financial Protection Bureau—renaming being the least arduous and hence an irresistible form of reorganization) a Presidential appointee—so he can squabble with the Fed’s chairman yet not be fired. The Federal Trade Commission, which is not protective of banks’ solvency, has extensive experience in protecting consumers, including consumers of financial products (the Commission enforces the Truth in Lending Act, for example), and could be given additional resources to police unfair and deceptive practices in mortgage and other consumer lending. While subprime lending contributed to the financial crisis, most subprime borrowers were not deceived, abused, intimidated, etc. Adjustable rate mortgages, strongly encouraged by Alan Greenspan, enabled people who could not afford the down payment on a house to buy a house anyway, gambling that continued housing price increases would give them an equity in the house that they could use to refinance with a conventional 30-year mortgage. If the gamble failed, they would go back to renting.

 

The new law increases the amount of equity capital that banks must hold, relative to their total capital, in order to reduce bankruptcy risk. But the Federal Reserve, in the case of commercial banks, and the SEC, in the case of nonbank banks (or the nonbank subsidiaries of commercial banks, such as Merrill Lynch, now a part of Bank of America), already have the authority to decide how much equity capital, relative to debt, the firms they regulate must hold.

 

The legislation requires that most credit-default swaps (a form of credit insurance, but also a device for speculating on bond prices and defaults) be traded through clearinghouses and on public exchanges, as publicly traded stocks are. Uncertainty about the liabilities and solvency of issuers of credit-default swaps did contribute to the financial panic of 2008, but can be dispelled by requiring fuller public disclosure of firms’ off-balance-sheet contingent liabilities, including not only credit-default swaps but also the “structured investment vehicles” in which banks parked their mortgage-backed securities. Requiring such disclosure is again within the existing authority of the financial regulatory agencies.

 

It may be argued in defense of the new law’s apparent redundancy that the agencies didn’t use their authority to avert the crisis (which is true), so they must be ordered to use it to avert future crises--which doesn’t follow. It is a mistake for Congress to instruct regulatory agencies on the details of how to regulate. The idea behind administrative regulation is that agencies hire experts to deal with technical issues that Congress has neither the competence nor the time to resolve. Legislation once adopted is difficult to change, and can squeeze a regulatory agency into a straitjacket. This is a particularly serious concern in the case of finance, an industry that experiences continuous change.

 

Besides trying to micromanage the regulatory process in some respects, the new law in other provisions takes a different tack and directs the regulatory agencies merely to study particular problems. This is a waste of ink. All the senior financial regulators are appointees of the Obama Administration. If there are areas of financial regulation that would benefit from further study—and there are—the White House can tell its appointees to do so. There is no need for a congressional prod.

 

There are little nuggets here and there, such as the abolition of the faitnéant Office of Thrift Supervision, but on the whole, so far as I can judge, the new law is a political measure in the worst sense.

Comments

[Gordon Longhouse]

Genuine reform would look like this:

1. A single prudential regulator for deposit-taking institutions. The number of agencies in the US that have a piece of prudential regulation of financial institutions is bewildering. Numerous regulators risks regulatory arbitrage and lacks transparency and accountability.

2. The brief of the prudential regulator to be solely prudential regulation. International competitiveness of financial institutions is not to be considered. The UK Financial Services Agency was directed to consider the competitiveness of its regulations internationally resulting in the deliberate slackening of capital standards and disaster for the UK.

The treatment of trust-preferred as capital mentioned by Becker, was brought about in order to give banks the advantage of cheap "capital". It's cheap because it is bogus.

3. Get rid of Freddie and Fannie. They were supposed to manage mortgage default risk in the system. Instead they concentrated it. Most free market economies with widespread home ownership get by just fine without a semi-government agency to re-finance home mortgages. It is absurd to suggest that the US, of all places, needs such a thing.

For Posner to say that it is not the bank's fault that they took on too much risk because the regulator was asleep at the switch is rather disgusting. It is as if a thief were to say that its thieving was society's fault for not having enough police. The banks and other financial institutions have to take primary blame for the crisis.

For one thing they were as much a part of the de-regulation craze as anyone. When the banks lobby Congress for MORE regulation you can blame the regulators to the exclusion of industry.

Finally Lehman Bros. had the opportunity to be rescued (by being sold to a Korean Bank) but turned it down. Against stupidity like this the Gods themselves act in vain.

[ed hardy]

http://www.ed-hardy.cc ed hardy
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[Per Kurowski]

The saddest part with the financial regulatory reform is that the most important issue has not even been raised.

Borrowers, if perceived to be more risky, should of course pay the banks higher interest rates.

But, just because the regulators decided to allow the banks to lend to others who are perceived as being less risky with lower capital requirements, the small businesses and entrepreneurs, on top of the risk-adjusted higher interest rates they pay, need to pay an additional 2 percent a year only to remain competitive when accessing bank credit.

If it is easier think of capital requirements as the “handicap” weights put on horses to make the race more equal… bank regulators are putting the heaviest weights on the weakest runners.

In tuff times when we precisely need tuff small businesses and entrepreneurs to get going this is sheer lunacy. Yet this issue is being totally ignored. Could you please help raise it?

http://subprimeregulations.blogspot.com/2010/07/basel-committee-makes-small-businesses.html

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[Dennis Tuchler]

You can't really blame a bureaucrat for not spotting a bubble. Assume the bureaucrat pops the bubble by raising interest rates. The opposing party, pundits and libertarian economists will beat the bureaucrat over the head, and there will be no way to prove that there was a bubble and that the popping was necessary at that time. The bureaucrat will lose his/her job and remain tagged with the blame for stopping economic growth.

[Kevin McGilly]

It's jarring to read a post as incoherent - and incorrect - as Posner's on the FinReg bill that is about to become law. Posner's basic claim is that the legislation is "redundant," because he says, Treasury, the Fed, SEC, and other regulatory agencies already have the authority to prevent financial crises like the one that started in 2008, but failed to exercise it. This is false. No agency had the type of resolution authority that would have enabled an orderly liquidation of Lehman Brothers, which Posner himself acknowledges was thr triggering event of the meltdown. The government faced a stark choice with Lehman - rescue it or let it collapse. Neither was a good option. If the bill had been law at the time, Treasury and the Fed could have coordinated an orderly dissolution.

Likewise, the crisis revealed that the giant non-bank financial services firms like Bear, Merrill, and Goldman had exploited gaps in the fragmented financial services regulatory structure, creating systemic risks that went unchecked. The new law closes the gaps by enabling coordinated action across agencies in a way that did not exist when the crisis occurred. And as even Posner reluctantly acknowledges, it also tightens capital requirements (albeit insufficiently) on financial institutions that have the scale to create systemic risk.

Posner is demonstrably wrong and injudiciously hyperbolic in calling the bill a "monstrosity."

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[Brian Davis, Austin, TX]

I suspect Judge Posner would like to say more about how monstrously impenetrable HR 4173 really is, but he's right to save it. Congress did enough on the banks with FIRREA in '89 and FDICIA in '91 to kill off TBTF, but members came and went, too many went to sleep at the switch when Al Gore invented the Internet. But Sandy Weill and Bob Rubin didn't snooze. They got their "financial supermarket" (Glass-Stegall repeal) validated by GLB in '99; Bill & Hillary Clinton got Fannie & Freddie for their pals and their social-leveling agenda. It was off to the races after that. Somebody tell me what would have been wrong, much less globally-destructive, to have run the hopelessly-insolvent nonbanks (Lehman, Bear, Merrill) through Chapter 7 bankruptcy if nobody among their competitors wanted to take them on. Or AIG's holding company, for that matter. A worthless security is a worthless security is a worthless security. A "market" predicated upon the exploitation of bagholders and the infinite creation of new ones isn't worth keeping. That's where HR 4173 falls short, IMHO. We're still kicking the pain down the road, overloading the Almighty Fed, and inviting Wall St to do it to us again.

[Jim]

Over reaction on the part of ignorant and venal legislators will lead to a counter over reaction by the financial world. Every time the feds try to fix something, they make it worse.

[Andrew]

As mentioned in other opinions on the matter, the bill continues to encourage a restriction to competition and entry in the financial markets. This will be great for the few large players. However, any Economics 201 class will tell you that this will increase inefficiency of the markets raising overall costs. Who will share these costs - the consumer. This thought is simple and a reoccuring issue with Keynesians and "big government" arguments.

The real question I have is: "This is bad in the short term, Will it matter in the long run?" The financial market, like other markets, is comprised of highly intelligent individuals playing in a supply and demand market. For the past 80 years, the financial markets have beat to a battle rhythm: crisis, regulation, normalization. And during the normalization period, banks have, through their intelligent owners, figured out how to play the regulations to their advantage. This bill, like previous others, has been unable to accurately predict the future - why should it? Some new un-thought-of market tool or product will allow the banks to perform high risk activities in order to make profit (e.g. credit cards).

The consumers will share the burden of inefficient markets until the competitors "normalize" the cost of products. This bill, unlike the past, will have particularly high costs in the short run as only the big banks will be allowed to play, because of the restricting nature of the regulation. In the long run, though, will supply and demand drive this price to its pre-2004 levels?

If I could predict the future, I would hope that international financial markets play a bigger role with the individuals. What I mean is, if I don't like the product offered by BOA, Citi, or Chase, nor the products offered by local farm bureaus, etc., and I don't like the insurance products offered by my local dealers or the big 6, will I be able to bank with a regional offering in China or Australia or Mexico. Can I be insured on my investments through an insurer in Japan and get a Mortgage loan through a bank in Turkey. If the United States is unable to estimate the future of international financial markets, I pray the rest of the world will.

[JOHN]

If I could predict the future, I would hope that international financial markets play a bigger role with the individuals. What I mean is, if I don't like the product offered by BOA, Citi, or Chase, nor the products offered by local farm bureaus, etc., and I don't like the insurance products offered by my local dealers or the big 6, will I be able to bank with a regional offering in China or Australia or Mexico. Can I be insured on my investments through an insurer in Japan and get a Mortgage loan through a bank in Turkey. If the United States is unable to estimate the future of international financial markets, I pray the rest of the world will.
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Mortgage

[SAURABH SRIVASTAVA]

The consumers will share the burden of inefficient markets until the competitors "normalize" the cost of products. This bill, unlike the past, will have particularly high costs in the short run as only the big banks will be allowed to play, because of the restricting nature of the regulation. In the long run, though, will supply and demand drive this price to its pre-2004 levels? thanksss
_____________
SAURABH SRIVASTAVA
Interest Rates
http://www.lowratesformortgages.com

[SAURABH SRIVASTAVA]

Once again great post. You seem to have a good understanding of these themes.When I entering your blog,I felt this . Come on and keep writting your blog will be more attractive. To Your Success!
________
saurabh srivastava
Interest Rates
http://www.lowratesformortgages.com

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