THE BEAR'S LAIR Regulatory Stooges
By Martin Hutchinson
Banking lobbyists must be dizzy right now. In the United States, they face
regulation from Senator Chris Dodd's banking committee and a draconian proposal
on derivatives from Senator Blanche Lincoln's Agriculture Committee. In
Britain, each of the three parties contesting the current election has
different ideas on how to regulate banks, but they're all agreed that something
must be done. The IMF has proposed two different bank taxes.
The Group of 20 finance ministers who met over the weekend may come up with
another proposal. Finally, the US Securities and Exchange Commission has filed
a civil fraud suit against Goldman Sachs, which if it expands rather than being
quickly settled, could itself provide some major new bumps in the financial
playing field.
There are two problems: most of these attempts at legislation are
mutually contradictory, and few of them address the problems that make the
financial system so dangerous. In other words, the current attempts to control
the financial system might as well have designed by the Three Stooges. Mind
you, since there were only three of the comic pratfall team, a Stooge-designed
system of regulation would presumably have involved a greater level of
coordination and thought.
Sensible changes in financial services regulation need to take a clear view of
what they are trying to achieve, and a focused minimalist approach to achieving
it. None of the above attempts does this.
The IMF proposal that banks be zapped with not one but two new taxes, one of
which would be applied to both profits and employee remuneration, makes no
sense at all (this is of course typical of proposals from that economically
superfluous and damaging body). Its most damaging effect would be on large
retail banks with sprawling heavily staffed branch networks, while small
hedge-fund operators with a few grotesquely overpaid staff would undoubtedly
find some loophole to avoid it. In any case, imposing random additional burdens
on the financial sector would merely have the effect of decapitalizing those
parts of it, such as retail banking and issue underwriting, that were
low-margin but actually useful.
The Roosevelt administration tried decapitalizing the investment banks in the
1930s, through the Glass-Steagall Act. This did huge economic damage, reducing
issue volumes in bond and stock markets to levels unseen in a generation,
thereby prolonging and deepening the Great Depression.
Instead of zapping the financial sector at random, regulatory reform should aim
at the three aspects of modern finance that are economically counterproductive.
First, it should cut down the rent-seeking in the sector, primarily through
reducing the volume and profitability of "fast trading" and exotic derivatives
products. Second, it should ensure that the sector's incentives are aligned so
that participants want to control risks properly and have the tools to do so.
Third, it should reduce the excessive focus on short-term trading, which turns
the financial markets into a casino and destroys its participants' ethical
standards.
Overall, regulatory reform must be combined with other reforms or it will fail.
In particular the Byzantine structure of federal support for the housing market
must be dismantled and the subsidization of leverage by ultra-low interest
rates and expansive monetary policy, which has distorted the US and global
economies for over a decade, must be ended. While mortgage-guarantors Fannie
Mae and Freddie Mac and Federal Reserve chairman Ben Bernanke still march on
unimpeded, the Wall Street problem remains insoluble.
The currently proposed reforms achieve none of these objectives, except
tangentially, and have the potential to cause new problems.
The Dodd bill in its current form does not address any of the problems. It
formalizes a mechanism for bailouts when the banking system goes wrong,
essentially giving up on the problem of preventing the system from crashing in
the first place. It does nothing about rent-seeking, nothing about incentives
and nothing about the sector's excessive focus on short-term trading. It also
adds various silly and damaging bits of bureaucracy, such as a four-month
inspection requirement for start-ups seeking "angel" venture capital funding.
Senator Lincoln's proposal to prevent banks with deposit insurance from
becoming huge players in the derivatives market is helpful in that it removes
the largest single risk from the commercial banking system. Its other proposal,
that standardized derivatives should be traded on an exchange, would be helpful
if it had no loopholes, but in its emerging loophole-ridden form it offers too
many avenues for off-exchange derivatives to remain gigantic opaque casinos as
they are today. Indeed, by allowing companies to avoid margin requirements
through trading off-exchange derivatives, the proposal leaves a gigantic
incentive towards opacity.
The IMF's proposed taxes on banks are "excessive, arbitrary and punitive" as
Canada's Finance Minister Jim Flaherty said on its announcement. Canada has a
well-behaved (albeit excessively oligopolistic) banking sector that avoided the
excesses of the bubble and has shown no great enthusiasm for entering the
riskier areas of finance even now. Indeed, the Canadian-owned brokerage TD
Ameritrade has put out an excellent paper asking for controls on "fast
trading", correctly pointing out that the liquidity advantages claimed for that
activity are spurious, since it makes prices ephemeral and prevents retail and
other investors from getting optimum executions. The IMF's tax proposals fail
to address the structure of banker compensation, or any of the other problems
of the sector. Hopefully they will sink without trace.
The party leaders at the British general election have generated two useful
contributions to the debate. One is Prime Minister and Labour Party head Gordon
Brown's support for a transactions tax, which directly addresses one of the
financial system's major problems. The other was Liberal-Democrat Nick Clegg's
remark, when asked to denounce bankers (his father was a banker and indeed a
former colleague of mine at the merchant bank Hill Samuel), that the older
generation of bankers is outraged by the sector's recent activities. Quite
right - and it reminds us that the current mess is not inevitable, if we can
find the right solution. Regrettably the Tory leader, David Cameron, has yet to
say anything useful on the subject, but there is always hope, I suppose.
Finally the SEC's civil fraud suit against Goldman Sachs, whether or not
ultimately successful, has thrown a valuable spotlight on the appalling ethical
standards of the modern Wall Street and the compete disregard for client and
investor interests that is inevitable in institutions whose top management are
bonus-remunerated traders.
Jeff-Skilling-like 25-year jail sentences for Goldman top management would seem
excessive for an institution whose activities differed little from its
competitors (they were also excessive for Skilling, but that's another story).
Forcing Goldman into bankruptcy, like Drexel Burnham in 1990, would also seem a
waste of the many talented people who work there. Nevertheless, if the suit
results in a Goldman win or a mere wrist-slap of a fine without as a minimum
dismantling Goldman into a proper investment bank and a hedge fund, then an
enormous opportunity will have been wasted.
Having examined the various wrong answers, some of which seem bound to make it
into law, we can be fairly confident of the right ones.
The Fed must be Volckerized, to ensure that never again does it engage in a
decade of populist bubble-blowing. (Paul Volcker, Federal Reserve chairman from
1979 to 1987 was widely credited with ending the United States' stagflation
crisis of the 1970s.) With sound money and solidly positive real interest
rates, the economic incentive to leverage is minimized.
Fannie and Freddie must be shut down, and the government must get out of the
home mortgage business, except if it wishes to provide marginal help for the
truly impoverished (which activity must be fully accounted for on a
mark-to-market basis, to prevent unexpected taxpayer liabilities from building
up).
We need a Tobin tax, perhaps at only 0.01% ad valorem on all trading, to reduce
or eliminate "fast trading" and other rent-seeking "skimming" of the market.
We need a bank breakup as suggested by Paul Volcker so that derivatives
operations and proprietary trading are separated from deposit-taking activities
(debt and equity underwriting, the original targets of the Glass-Steagall Act,
seem much less harmful).
We need derivatives cleared across exchanges, and standard derivatives traded
across exchanges. That will prevent the construction of networks of
counterparties as at Bear Stearns and AIG, that might require the rescue of an
otherwise doomed institution. It will also minimize rent seeking from opaque
trading activities. Companies that are foolish enough to want to "hedge"
themselves in the derivatives market (which hedging under FAS155 mark-to-market
accounting almost always results in wild swings in reported profits that are
completely impenetrable to shareholders) can put up with the costs and risks of
the margin system.
Dividends must become tax deductible for corporations. This would level the tax
playing field between debt and equity, while ensuring that management pays most
earnings to shareholders rather than keeping them for empire-building.
The Basel Committee that is attempting to salvage the international Basel II
capital standards must instead move to a Basel III that mandates a high level
of capital, probably 8-10% at the Tier 1 level, based on all assets without
"haircuts" for mortgages and government debt. It must also mandate risk
management "litmus tests" for large banks that reverse the incorrect Gaussian
assumptions of the failed value-at-risk system. Risk distribution "tails" must
be assumed to be both "fat" and "long." (My apologies to non-technical readers
here; not only could I write a book about this, I have, together with Professor
Kevin Dowd. Alchemists of Loss will appear from Wiley's shortly).
Profit-based remuneration and stock options, whether in banks or corporations,
must be paid out only over a five-year period and subject to recapture if
losses appear. (As a free-marketer, I hesitate to recommend laws setting pay
standards, but at least for an interim period of say 10 years, they appear
necessary to correct existing pathologies).
That would be a set of legislative and other changes that would solve the
endemic current problems in the world's financial system. It is of course
vanishingly unlikely to be implemented. Instead, we are doomed to be regulated
by Curly, Larry and Moe.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-2010 David W Tice & Associates.)
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