Page 2 of 5 POWER WITHOUT CREDIBILITY, Part 3 Politics of the financial crisis
By Henry CK Liu
Using the PPIP to bailout every community bank's shareholders and non-deposit
creditors is a waste of taxpayers' funds and will hurt healthy community banks
because they have to compete with zombie banks kept upright with taxpayer
money. A much more efficient use of taxpayer funds would be to shore up the
deposit insurance fund so the FDIC can afford to restructure banks before their
losses mount uncontrollably.
Yet the Congressional Oversight Panel's August 2009 report seems to be
advocating propping up zombie banks. That is very expensive, and does not help
otherwise good borrowers get good credit rating.
International exit coordination
World leaders on September 3, 2009, announced the first steps toward
withdrawing emergency support for the global economy
even though they warned that the crisis was far from being over. The US, UK,
France and Germany called for work to start "on exit strategies to be
implemented in a coordinated manner as soon as the crisis is over".
Treasury Secretary Geithner said finance ministers should start to spell out
how the "very successful policy response" to the economic crisis could be
reversed, presumably without also reversing their alleged success. Speaking at
the US Treasury press room before flying to London for a meeting of finance
ministers of the Group of 20 nations, Geithner said these exit strategies were
"very important to confidence" for the financial markets, with the unintended
implication that the allegedly "very successful policy responses" would
undermine market confidence if not reversed soon.
Writing in the Financial Times on September 3, Geithner said that the safety
nets that governments have put in place to limit the fallout from instability
resulting from excessive leverage have a cost because they insulate financial
institutions from the full consequences of their actions and can diminish
market discipline. Such moral hazard needs to be contained through regulation
that requires financial institutions to maintain reserves and capital buffers
in proportion to their risk so that they can absorb losses at their own expense
and not at the taxpayers'.
Geithner acknowledged that the "regulatory framework failed last year [2008]".
In the benign atmosphere before the crisis, government supervisors and those in
the market underestimated risks building in the system. Major global financial
institutions maintained capital levels that were too low, relied too heavily on
unstable short-term funding, and their compensation plans rewarded excessive
risk-taking. Larger banks often held less capital relative to their risks and
used more leverage than smaller banks.
The resulting distortions helped make our global financial system dangerously
fragile. As that system grew in size and complexity, it became more
interconnected and vulnerable to contagion when trouble occurred, Geithner
said.
But such practices did not evolve innocently. The net capital rule created by
the Security Exchange Commission (SEC) in 1975 required broker-dealers to limit
their debt-to-net-capital ratio to 12-to-1, and such firms had to issue early
warnings if they began approaching this limit, and were forced to stop trading
if they exceeded it. So broker-dealers often kept their debt-to-net capital
ratios much lower than 12-1. The rule allowed the SEC to oversee
broker-dealers, and required firms to value all of their tradable assets at
market prices.
The rule applied a haircut, or a discount, to account for the assets' market
risk. Equities, for example, had a haircut of 15%, while a 30-year Treasury
bill because it is less risky had a 6% haircut. But a 2004 SEC exemption -
given only to five big firms which lobbied intensively for the exemption -
allowed them to lever up 30 and even 40 to 1.
The five big investment banking firms wanted an exemption for their brokerage
units from the 1975 regulation that had limited the amount of debt they could
take on to $12 for every dollar of equity. The debt-to-net-capital ratio
exemption would unshackle billions of dollars held in reserve as a cushion
against potential losses on their investments and trades. The released equity
funds from higher leverage allowance could then flow up to the parent company,
enabling it to speculate in the fast growing but opaque world of
mortgage-backed securities, credit derivatives, and credit default swaps (a
form of insurance against counterparty default in order to maintain top credit
rating), and other exotic structured finance instruments that only
highly-trained mathematicians understand, based on models that are beyond the
comprehensive of most traders.
This brave new approach, which all five qualifying broker-dealers - Bear
Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley -
voluntarily adopted, altered the way the SEC measured their capital. The five
big firms, three of which became insolvent in 2009, led the charge for the net
capital rule change to promote financial innovation, spearheaded by Goldman
Sachs, then headed by Henry Paulson, who two years later, would leave Goldman
to become Treasury secretary and until the departure of the George W Bush
administration on January 20, 2009 had to deal with the global mess he helped
to create.
Lehman Brothers had gone bankrupt, Bear Stearns and Merrill Lynch had been sold
to big commercial banks with access to Fed money and Goldman and Morgan Stanley
have turned themselves into regulated bank-holding companies to avail
themselves the benefit of access to Fed money. The age of independent
stand-alone investment banks came to an end in the US. (See The
Folly of Intervention, Part One, Asia Times Online, January 22, 2009.)
The Treasury White Paper, "Financial Regulatory Reform: A New Foundation",
spells out five key objectives of reform: 1. Promote robust supervision and regulation of financial firms with:
A new Financial Services Oversight Council of financial regulators to identify
emerging systemic risks and improve interagency cooperation;
New authority for the Federal Reserve to supervise all firms that could pose a
threat to financial stability, even those that do not own banks;
Stronger capital and other prudential standards for all financial firms, and
even higher standards for large, interconnected firms;
A new National Bank Supervisor to supervise all federally chartered banks;
Elimination of the federal thrift charter and other loopholes that allowed some
depository institutions to avoid bank holding company regulation by the Federal
Reserve;
The registration of advisers of hedge funds and other private pools of capital
with the SEC. 2. Establish comprehensive supervision of financial markets with:
Enhanced regulation of securitization markets, including new requirements for
market transparency, stronger regulation of credit rating agencies, and a
requirement that issuers and originators retain a financial interest in
securitized loans;
Comprehensive regulation of all over-the-counter derivatives;
New authority for the Federal Reserve to oversee payment, clearing, and
settlement systems; 3. Protect consumers and investors from financial abuse:
A new Consumer Financial Protection Agency to protect consumers across the
financial sector from unfair, deceptive, and abusive practices;
Stronger regulations to improve the transparency, fairness, and appropriateness
of consumer and investor products and services;
A level playing field and higher standards for providers of consumer financial
products and services, whether or not they are part of a bank; 4. Provide the government with the tools it needs to manage financial
crises with:
A new regime to resolve non-bank financial institutions whose failure could
have serious systemic effects;
Revisions to the Federal Reserve's emergency lending authority to improve
accountability; 5. Raise international regulatory standards and improve international
cooperation with:
International reforms to support our efforts at home, including strengthening
the capital framework; improving oversight of global financial markets;
coordinating supervision of internationally active firms; and enhancing crisis
management tools.
To promote national coordination in the insurance sector, which is regulated by
a state insurance commission in each state, the report proposes the creation of
an Office of National Insurance within Treasury.
Under the report's proposal, the Federal Reserve and the FDIC would maintain
their respective roles in the supervision and regulation of state chartered
banks, and the National Credit Union Administration would maintain its
authorities with regard to credit unions. The SEC and Commodity Futures Trading
Commission would maintain their current responsibilities and authorities as
market regulators, though the Treasury proposes to harmonize the statutory and
regulatory frameworks for futures and securities.
The September 2009 G-20 ministers meeting in London set its aim to move forward
on reforms to put the global financial system on firmer ground. In his June 17,
2009 remarks on "21st century financial regulator reform", President Barack
Obama outlined a new regulatory framework that promotes stronger protections
for consumers and investors and greater financial stability. Making the system
safer requires a comprehensive approach, including tougher regulation of
derivatives, securitization markets and credit rating agencies, new executive
compensation standards and, critically, more powerful tools for governments to
wind down firms that fail. Geithner said the Obama administration is working
with foreign partners to ensure similar reforms are put in place by governments
around the world.
Geithner set out eight principles for regulatory reform, including one that
would force banks to raise far more capital by issuing new shares. It would
also set absolute limits on the amount of money a bank could borrow relative to
its capital cushion. The proposal has received broad support from UK Chancellor
of the Exchequer Alistair Darling.
However, the proposals have caused disquiet in Paris. French Finance Minister
Christine Lagarde told a press conference in London that changes proposed to
existing capital rules for banks - known as Basel II - should be enough to
ensure lenders hold a satisfactory level of capital. "We need to have a good
and sound explanation among ourselves concerning what Basel II is about. It has
been significantly improved, amended over time ... and, as revised, I would
have thought that addressed the issue," she said. Instead, Lagarde added,
France would like to see the debate on bankers' bonuses at the heart of
discussions about reforms.
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