United States Treasury Secretary Tim Geithner and National Economic Council
Director Larry Summers jointly wrote an op-ed piece in the Washington Post on
Monday, June 15, to lay out the policy goal of the Barack Obama
administration's regulatory reform plan to be announced two days later.
The essay describes the current financial crisis as "the product of basic
failures in financial supervision and regulation", by pointing out that "our
framework for financial regulation is riddled with gaps, weaknesses and
jurisdictional overlaps, and suffers from an outdated conception of financial
risk. In recent years, the pace of innovation in the financial sector has
outstripped the pace of regulatory modernization, leaving entire markets and
market participants largely unregulated."
Yet the administration's regulatory reform plan is generally viewed
as having backed away, due to the political difficulties involved, from a more
extensive structural overhaul that would have consolidated all banking
regulation into one unified agency.
The op-ed essay identifies "five key problems in our existing regulatory regime
- problems that, we believe, played a direct role in producing or magnifying
the current crisis".
The essay states: "First, existing regulation focuses on the safety and
soundness of individual institutions but not the stability of the system as a
whole. As a result, institutions were not required to maintain sufficient
capital or liquidity to keep them safe in times of system-wide stress. In a
world in which the troubles of a few large firms can put the entire system at
risk, that approach is insufficient. The administration's proposal will address
that problem by raising capital and liquidity requirements for all
institutions, with more stringent requirements for the largest and most
interconnected firms. In addition, all large, interconnected firms whose
failure could threaten the stability of the system will be subject to
consolidated supervision by the Federal Reserve, and we will establish a
council of regulators with broader coordinating responsibility across the
Yet, capital adequacy for large financial firms, while important, will not by
itself eliminate systemic risk since systemic meltdown can be caused by massive
counterparty defaults on the part of large number of small firms and investors
holding structured financed instruments that are off the balance sheets of the
big firms to cause insolvency of the big firms.
The problem is that even small firms are now "too big to fail" because of
opaque interconnectedness that can cause the system to fail not at its big
nodes but at its weakest points throughout the system. The administration's two
top economists do not see fit to blame run-away "innovation", only the failure
of regulation to keep pace with it. That is like blaming bank guards for bank
The essay states: "Second, the structure of the financial system has shifted,
with dramatic growth in financial activity outside the traditional banking
system, such as in the market for asset-backed securities. In theory,
securitization should serve to reduce credit risk by spreading it more widely.
But by breaking the direct link between borrowers and lenders, securitization
led to an erosion of lending standards, resulting in a market failure that fed
the housing boom and deepened the housing bust. The administration's plan will
impose robust reporting requirements on the issuers of asset-backed securities;
reduce investors' and regulators' reliance on credit-rating agencies; and,
perhaps most significant, require the originator, sponsor or broker of a
securitization to retain a financial interest in its performance. The plan also
calls for harmonizing the regulation of futures and securities, and for more
robust safeguards of payment and settlement systems and strong oversight of
'over the counter' derivatives. All derivatives contracts will be subject to
regulation, all derivatives dealers subject to supervision, and regulators will
be empowered to enforce rules against manipulation and abuse."
The non-banking financial system is essentially an anti-banking system in that
it allows securitization to convert debt into security; that is, credit into
capital. It is an insurgent war against capitalism itself. Pension funds are
allowed to invest in debt instruments as if they were security instruments.
Such instruments are in reality stripped of security, with returns commensurate
with risk levels. The word security is derived from the Ancient Greek se-cura
and literally translates to "without fear". Structural finance actually
promotes fearlessness that no regulation can negate.
The essay states: "Third, our current regulatory regime does not offer adequate
protections to consumers and investors. Weak consumer protections against
subprime mortgage lending bear significant responsibility for the financial
crisis. The crisis, in turn, revealed the inadequacy of consumer protections
across a wide range of financial products - from credit cards to annuities.
Building on the recent measures taken to fight predatory lending and unfair
practices in the credit card industry, the administration will offer a stronger
framework for consumer and investor protection across the board."
Improved consumer protection is certainly needed, but the best way to protect
the consumer is to adopt a full-employment economy with rising wages so that
workers do not have to assume unsustainable debt in order to buy the products
The essay states: "Fourth, the federal government does not have the tools it
needs to contain and manage financial crises. Relying on the Federal Reserve's
lending authority to avert the disorderly failure of nonbank financial firms,
while essential in this crisis, is not an appropriate or effective solution in
the long term. To address this problem, we will establish a resolution
mechanism that allows for the orderly resolution of any financial holding
company whose failure might threaten the stability of the financial system.
This authority will be available only in extraordinary circumstances, but it
will help ensure that the government is no longer forced to choose between
bailouts and financial collapse."
There is no "appropriate" government mechanism to contain and manage financial
crises. The solution is to prevent recurring financial crises. A new resolution
mechanism to shift private debt into public debt does little to prevent
recurring financial crises. In fact, it may well make such crises routine.
The essay states: "Fifth, and finally, we live in a globalized world, and the
actions we take here at home - no matter how smart and sound - will have little
effect if we fail to raise international standards along with our own. We will
lead the effort to improve regulation and supervision around the world."
US promotion of neoliberal globalization of trade and finance has been the main
cause of recurring global financial crises. The lack of international labor
standards and wage scales has permitted US corporations to exploit cross-border
wage arbitrage that has caused global wage stagnation to generate wage/price
imbalance, notwithstanding the essay's misapplied claim of a saving/consumption
imbalance. US opposition to international financial regulatory standard has
allowed US financial firms to exploit cross-border arbitrage of risk in the
name of innovation.
Neither the op-ed essay nor the administration's plan addresses the need for a
federal regulatory regime for the insurance sector, which is now governed by
state insurance commissions in a tradition of state rights. This issue is
particularly central since under-regulated financial risk insurance practices
have been a key contributor to run-away systemic risk.
The administration aims to curb excessive risk-taking through reform of
structured finance and compensation practices that encourages risk taking,
including "say on pay" for shareholders and regulation against abuses of risk
induced by short term compensation while leaving the penalty of future loss to
Under the Obama plan, the Federal Reserve will retain day-to-day supervision of
the largest bank-holding companies, which the George W Bush administration had
proposed taking away. The Fed may become the sole regulator for both banks and
non-bank financial companies that reach a comparable size and complexity. The
Fed is also likely to be given the final authority on bank capital
requirements, including a surcharge for the systemically important financial
However, not all systemic risk powers will be concentrated in the Fed. The
Obama plan will propose giving the Federal Deposit Insurance Corporation (FDIC)
special resolution powers to wind down important large financial institutions.
These powers will extend the capacity of FDIC to manage the orderly failure of
a complex financial company, which policymakers hope will mitigate the moral
hazard created by recent bail-outs.
Nonetheless, the plan places great reliance on the Fed, which is likely to be
controversial in Congress, with critics charging that the Fed had failed to
exert its existing regulatory powers over banks in mortgage lending.
Fed chairman Ben Bernanke believes that macroprudential powers (systemic risk
powers) may allow a central bank to prevent credit and asset price bubbles not
easily addressed with interest rates. But other Fed officials are apprehensive
that the central bank is setting itself up for predictable failure, and that
the exercise of macroprudential powers will entangle the Fed in political
fights that will undermine independent monetary policy-making.
Larry Summers likes to say the Obama administration inherited the financial
crisis from the Bush administration, but the Obama plan for regulatory reform
essentially inherits the plan of Henry Paulson, the last Treasury secretary in
the Bush administration. Paulson advocated consolidation of a regulatory regime
"largely knit together over the last 75 years, put into place for particular
reasons at different times and in response to circumstances that may no longer
The Geithner plan eliminates the Office of Thrift Supervision (OTS), which
oversaw an array of collapsed large institutions such as IndyMac, Washington
Mutual and AIG. The OTS is to be merged with the Office of the Comptroller of
the Currency (OCC). The shotgun marriage was first proposed by Paulson.
Paulson also wanted to merge the Commodity Futures Trading Commission (CFTC)
into the Securities and Exchange Commission (SEC) to ensure that derivatives,
the weapons of mass financial destruction, would be properly put under
financial arms control. The proposal is not in the Geithner plan, not because
the Treasury did not like the idea but because the CFTC, with long historical
ties to Chicago, has a powerful lobby. But the SEC will have to devolve some
power to a new commission responsible for supervising consumer financial
Plans on securitization will force lenders to retain at least 5% of the credit
risk of loans that are securitized. Asset-backed securities and the entire
over-the-counter derivatives market will face new reporting rules. Large
"systemically risky" institutions will have to hold more capital, and hedge
funds will have to provide more data on their trading positions.
George Soros, the speculator who broke the Bank of England over its defense of
the pound sterling, said in the Financial Times that a requirement for lenders
selling securitized loans as securities to retain 5% exposure "is more symbolic
than substantive". Yet the wider regulatory reform plan has already attracted
criticism from bankers who say it will add to the cost of capital.
Republicans are preparing to fight several of the Obama proposals, with
lawmakers particularly skeptical about giving more powers to the Federal
Reserve, even though much of the Obama plan has been inherited from the
previous Republican administration.