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     Sep 17, 2009
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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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