2010 March 09
Click on History for changes and updates.
The continuation of this post is my letter to Professor Elizabeth Warren, chairman of the TARP Oversight Committee, concerning legislation to prevent a repeat of the financial collapse in 2008. My conclusion is that clear requirements in the law are needed. Laws that provide discretion to bureaus have demonstrated that they cannot consistently provide the protections intended.
(added 2011 Nov 16) See The Next Crisis – Ballooning National Debt? concerning Canadian national debt. Canada began a debt reduction effort in the late 1990s.
Don Nordeen
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- Key Words: Economy, Financial Systems Policy, National Economy, Public Policy Issues, real estate collapse, Wall Street, Main Street, banks, banking, banking regulation, laws, regulations, credit default swaps, mortgage-backed securities, securities ratings
Laws and Regulation of Financial Institutions (continued)
2010 March 09
Professor Elizabeth Warren
Harvard Law School
Dear Professor Warren:
Subject: Laws and Regulation of Financial Institutions
The impasse in developing a consensus on new legislation for regulation of financial institutions presents a new opportunity — one to address the concerns raised on some aspects and to build on aspects where there is a consensus. This letter provides a few thoughts and offers some suggestions. I plan to provide a separate letter on the credit card issues.
I believe the TARP Oversight Committee has established a compelling analysis of the 2008 financial collapse, and should consider making refined recommendations to Congress based on the actions taken and not taken in both the House and the Senate. My thoughts for consideration are:
- Legislation with clear standards and/or prohibitions works. — The best example may be the Glass-Steagall Act. It worked its magic 24/7 for 60 years and its repeal was a factor in the major financial collapse that occurred in 2008. Disclosure requirements defined in law work.
- Regulations are not reliable in preventing major collapses. — Alternatively, gate keepers don’t work. “Gate keepers” are expected to take action to prevent some future unwanted event, or to stop a practice that the “gate keeper” believes will result in some future unwanted event. However, the “gate keeper” will have to take that critical action while most everything is going well, and will therefore be vilified for taking what others will call an unnecessary restrictive action — the sky is falling, chicken little. None of the gate keepers sounded any alarm or took strong action to head off what occurred in 2008.
- Any legislation authorizing regulation must be specific, clear and limited. — Such legislation provides the clear charter that cannot be eroded away by the strong and ongoing lobbying of the regulators for the institutions affected. The best example of what works is FDIC which has the clear and limited charter to protect depositors’ money. In doing so, it prevents runs on banks. The SEC has been less successful for many reasons with too many “failure” examples.
- And Others — Address the “too big to fail” with progressively more stringent reserve requirements with size in the law. for larger banks and financial institutions Address the diversification issue in the law with maximum investment limitations by sector based on the root asset or collateral. Treat derivatives, credit default swaps, etc. as insurance products and regulate with the combination of law and regulations that works for insurance. Mortgage-back securities cannot become toxic.
The Appendix discusses these and other thoughts and includes a discussion of related issues. Again, my recommendation is for the TARP Oversight Committee to provide a refined analysis and recommendations to both the House and the Senate.
Sincerely,
Donald L. Nordeen
Appendix — Further Thoughts and Discussion
File: >>WarrenE00309 LawsFinancial.cwk
Appendix — Further Thoughts and Discussion
Laws and Regulation of Financial Institutions
Your analysis of the history paints a clear picture of 60 years of relative financial security with the laws and regulations after the great depression: Glass-Steagall Act, Securities and Exchange Commission, Federal Deposit Insurance Corporation, etc. I have watched videos from a number of your interviews in which you make the case for reform extremely well. However, I believe more of the reform requirements should be in the legislation with less dependence on regulators. I am not sure that we learned enough from the savings and loan debacle. Before discussing some possible different approaches, I believe some lessons from history concerning human nature are in order.
- Legislation with clear standards and/or prohibitions works. — The best example may be the Glass-Steagall Act. It worked 24/7 for 60 years without bureaucrats. On the other hand, the SEC has worked less well. Disclosure requirements defined in law work. Accounting standards also work, particularly when combined with disclosure requirements, but the changes and plans are uncertain which is a factor in SEC’s limitations. The monopoly issues concerning Microsoft were resolved by litigation, not be regulation or by regulators. Legislation with clear standards and/or prohibitions eliminates the need for an army of bureaucrats.
- Oppose ambition with ambition — Our founding fathers, particularly James Madison, recognized the influence of ambition leading to monopoly, power and control. Rather than to try to prohibit the effects of ambition (the knee-jerk to command and control laws and regulation), he advocated opposing ambition with ambition, resulting in the checks and balances and separation of powers. We should learn from the many benefits from this philosophy and create similar powerful self-regulating checks and balances to prevent ambition from undermining our financial system as occurred in the last decade. Not easy, but necessary. The ambition from regulatory agencies is another example of monopoly, power and control. As Milton Freedman describes, financial bureaucrats end up managing other people’s money for still other people in a way that enhances the interests of the bureaucrats.
- Irrational exuberance — This is Alan Greenspan’s term, but it is much more than that. It also involves urgency, anxiety, frenzy, fear and greed. It involves taking an action that is not well founded because others are reaping high benefits from doing so resulting in a fear of losing out on the benefits — “eating the forbidden fruit”. It is a frenzy to take advantage of perceived high return while rationalizing the risks. It is stampeding to decision because of precarious anxiety about the possibility of missing out on an opportunity — of missing the “gravy train”. This human emotion is at the heart of the boom-and-bust cycles. “Fear of missing the gravy train” is more descriptive that irrational exuberance. This works mostly on the short term.
- Gate keepers don’t work — Often, administrative departments are set up to be gate keepers with broad authorizing powers (discretion to the Secretary without defining specifics or limitations). I believe another important observation is that “gate keepers” cannot supply consistent opposing ambition because of their self interest to avoid taking the heat. “Gate keepers” are expected to take action to prevent some future unwanted event, or to stop a practice that the “gate keeper” believes will result in some future unwanted event. However, the “gate keeper” will have to take that critical action while most everything is going well, and will therefore be vilified for taking an unnecessary restrictive action — the sky is falling, chicken little. Further, if the “gate keeper” prevails and the future unwanted event never occurs, only a few people will credit the “gate keeper” for his/her courage. Recognition would be minimal. Job security for the “gate keeper” is not consistent with the inherent risk of “closing the gate”. None of the gate keepers sounded any alarm or took strong action to head off what occurred in 2008. Moreover, the pressure on gate keepers from those being regulated to relax the requirements will be strong and ongoing. None of the “gate keepers” acted to prevent the 2008 financial collapse. Not Greenspan, not Bernanke, not Paulson, not Geithner. Most interesting is that Alan Greenspan acknowledged that his model of markets was not correct. Also, most regulated financial institutions didn’t act either. Most notable is Robert Rubin who had moved on to CitiGroup. Larry Summers didn’t sound a warning either.
- Any legislation authorizing regulation must be specific, clear and limited. — Such legislation provides a clear charter that cannot be eroded away by lobbyists for the institutions affected. The best example is FDIC which has the clear and limited charter to protect depositors’ money. In doing so, it prevents runs on banks. The SEC has been less successful for many reasons.
It seems to me that the place to start is to go back to 1975, identify what the US had in place, and try to understand where the pressures for change came from, what changes were made and their effects. The first step in the erosion of the protections may be the Community Reinvestment Act of 1977. It set the stage for a relaxation of the mortgage standards for the next 30 years. The analysis should also consider relaxation of the legislative requirements, including the Gramm-Leach-Bliley Act (CFMA), also known as the Financial Services Modernization Act of 1999, which repealed some aspects of Glass-Steagall and clearly is a factor in the “too big to fail” scenarios. As you have pointed out, we have the opportunity to learn from other countries on what has worked well and worked poorly. The legislative changes suggest that the lessons of history were lost, or believed to no longer apply. Two generations later, the benefits from Glass-Steagall were no longer appreciated and taken for granted as being provided by the markets. My reading suggests a few ideas.
- Learn from Canada — Several writers have indicated that Canada weathered the financial crisis better than others. For example, Fareed ZakariaFN1 writes, “Keep in mind that the one advanced industrial country where the banking system has weathered the storm superbly is Canada, which just kept the old rules in place, requiring banks to hold higher amounts of capital to offset their liabilities and to maintain lower levels of leverage. A few simple safeguards, and the whole system survived a massive storm.”
- More focus on the short term — This may seem backwards, but the short term creates the noise and confusion that masks the longer-term risk. The “fear of missing the gravy train” is short term. Robert SamuelsonFN2 writes, “Joseph Schumpeter, one of the 20th century's eminent economists, believed that capitalism sowed the seeds of its own destruction. Its chief virtue was long term — the ability to raise wealth and living standards. But short-term politics would fixate on its flaws — instability, unemployment, inequality.” But instability is a factor in weeding out the uncompetitive businesses and practices. Crafting legislation to reduce the instability is a challenge, but necessary. Better disclosures of risks and long-term consequences are important.
- Investment rating agencies. — These must be independent from the financial institutions offering the financial products. I don’t have any problem with the agencies being engaged by buyers and accountable to buyers. The ratings were too procedural and subject to being manipulated. The rating agencies should provide a risk assessment. This is very difficult to do with complex mortgage-backed securities, which should not be packaged in a way that thier risks and value become unknown and maybe unknowable. Crafting legislation to accomplish these objectives is a challenge but necessary.
- New Laws should be comprehensive, contingent and cost-effective — These broad requirements are advocated by Raghuram RajanFN3 who argues for a regulatory system that is immune to boom and bust. Mr. Rajan is a professor at the University of Chicago Booth School of Business and a former chief economist of the IMF. He also writes, “To have a better chance of creating stability through the cycle — of being cycle-proof — new regulations should be comprehensive, contingent and cost-effective.” I equate that with legislation focused on restrictions based on the fundamentals. He cautions against the natural tendency to over-regulate when conditions are poor and under-regulate when conditions are good. Comprehensive does not mean complex; it means simple powerful requirements with the necessary scope. I subscribe to the saying from Oliver Wendell Holmes, “For the simplicity on this side of complexity, I wouldn't give you a fig. But for the simplicity on the other side of complexity, for that I would give you anything I have.”
- Include the diversification issue in the law. — Instability in the markets can be reduced by broader diversification. It is not just the first layer of diversification, but diversification of the root assets or collateral. Defining and understanding the root collateral is an important aspect of mortgage back securities. Without clear definition, they can become toxic with no basis for estimating their value in a down market.
- Derivatives and credit default swaps must be simple products. — These are variations of insurance products and should be regulated by legislation and regulations known to work for other insurance products. They should be simple products for which the risks and obligations are clear.
- Regulators cannot be relied upon. — For many reasons (See “gate keepers” don’t work; also experts tend to have closed minds.), regulators are not reliable sources for identifying future disastrous potentials and acting upon their beliefs. The SEC didn’t stop the Madoff ponzi scheme even with strong inputs from outsiders. The Community Reinvestment Act of 1977 provided the political influence on the mortgage regulators who complied with relaxation of mortgage standards. The regulators were unable or unwilling to resist.
None of the high-level regulators anticipated the 2007-2008 financial crisis, including Alan Greenspan, Robert Rubin, Larry Summers, Ben Bernanke, • • •. While he was Secretary of the Treasury, Rubin described that markets depend upon confidence in addition to value and that loss of confidence is difficult to predict. Yet his leadership resulted in CitiGroup needing the large bailout. The exception was Brooksley Born who headed the the Commodity Futures Trading Commission [CFTC], and attempted to take action concerning the dark market for derivatives. See the PBS Frontline documentary, “The WarningFN4”. She was totally beaten down by the experts at Treasury and Federal Reserve. Those experts acted to create less restraint on markets. The Commodity Futures Modernization Act of 2000 (CFMA) eliminated the authority of CFTC to regulate derivatives. Frontline did not cover The Gramm-Leach-Bliley Act (CFMA), also known as the Financial Services Modernization Act of 1999, which repealed some aspects of Glass-Steagall and clearly is a factor in the “too big to fail” scenarios. Likely, most members of Congress did not understand the potential consequences from CFMA and CFMA.
- Regulators yield to the financial services industry. — The history is clear on this. The lobbying is intense. The profits to be made with relaxed reserves, etc. drive the deregulation and increase the risk. The indirect influence on regulators from the lobbying on Congress is also major.
- Illustration with Glass-Steagall — I know there is strong opposition from the investment banking community against restoration of Glass-Steagall. The purpose of the legislation is to protect the people, not serve the financial institutions. Glass-Steagall is the recommendation of John Bogle, founder of the Vanguard Fund and a critic of the increased costs imposed on investors in the mutual fund industry. The Volker rule is less stringent. Regardless, the protection for the people needs to be in the law. Restoration of Glass-Steagall automatically addresses the “too big to fail”.
Perhaps the major reason for the opposition to Glass-Steagall is the claim by large banks of a loss of competitiveness in the international markets. I would counter that if the USA restored Glass-Steagall, the other countries would more clearly understand the risk to their banking systems of not following suit. If repeal of Glass-Steagall will adversely affect the people in some indirect way, then the financial services industry should provide a clear analysis and explanation to support its claim. The industry should be a fact provider and source of competent analysis and explanation, not a dictator of what the legislation should be.
The challenge is to write comprehensive, simple, powerful legislation that will protect the American depositor/investor 24/7 for many years to come. My daughter, who has a Ph.D. in political science and philosophy from that other Ivy League University and has taught at University of Virginia and University of Chicago, agrees with the legislative approach but cautions not to underestimate the challenge of getting the legislation right.
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FN1 Fareed Zakaria, “The Capitalist Manifesto: Greed Is Good (To a point)”, Newsweek, Jun 22, 2009, http://www.newsweek.com/id/201935
FN2 Robert J. Samuelson, “Rage Could End Up Hurting Us”, Newsweek, Mar 30, 2009, at http://www.newsweek.com/id/190347
FN3 Raghuram Rajan “Cycle-proof regulation” Apr 8th 2009. From The Economist print edition, http://www.economist.com/ businessfinance/displayStory.cfm?story_id=13446173. Also available at Cycle-proof regulation at http://www.econ.puc-rio.br/Mgarcia/Seminario/Seminario_textos/090529%20cycle%20proof%20regulation-2.pdf
FN4 See PBS Frontline, “The Warning” broadcast on 2009 Oct 27. Video and other information available at http://www.pbs.org/wgbh/pages/frontline/warning/view/.
- History: 0
- 2010 Mar 09 — Initial Post
- Links: Laws and Regulation of Financial Institutions at [http://swagman.typepad.com/curmudgeon/2010/03/laws-and-regulation-of-financial-institutions-1.html]
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