Stanford Progressive

Righting Republican (and Democratic) Wrongs: A Review of Financial Reform

By Ross Raffin, published August, 2010

Arguing that voting for the current financial reform bill equates to bail-outs is the same as arguing that no one should have voted for the 1964 Civil Rights Act because it enforces Jim Crow. Deregulation trends from the past few decades alongside evolving financial markets created huge regulatory gaps which were exploited by groups such as AIG, Goldman Sachs, hedge funds, investment banks, Fannie Mae and Freddie Mac, and the Federal Reserve. The Restoring American Financial Stability Act (RAFSA) aggregates the fixes proposed by policymakers across the spectrum, from liberal Nobel prize winning economist Paul Krugman to former Federal Reserve Chairman under Reagan Paul Volcker. Senate Democrats knew Republicans would not block debate forever because many Republicans want this bill; the only thing holding them back was Minority Leader Mitch McConnell’s largely impotent arm-twisting. This is unsurprising, since RAFSA addresses some of America’s largest financial problems including the moral hazard, a secretive Federal Reserve, toxic assets, and the idea of being “too big to fail.”

The Great Depression truly sparked when a large number of people independently decided they wanted to get all of their money out of their bank at the same time. Banks loan out more money than they have, a practice which works as long as people only occasionally ask for their money. If everyone asks for their money at the same time, the bank must admit all the money was lent out. Suddenly, everyone invested in that bank is penniless. News spread of this, and everyone realized the same thing might happen at their bank. This psychologically based panic swept across the nations banks, destroying the savings of millions of Americans. The way to fight bank runs is to increase confidence in banks so people do not simultaneously ask for their money.

To this end, the government established the Federal Deposit Insurance Company (FDIC). If, at some future point, all of a bank’s customers simultaneously ask for their money, the FDIC will pay for any money the bank doesn’t have. This means bank customers don’t have to rush to withdraw upon hearing of other banks closing. Ideally, this stops bank runs as long as the government has the ability to fund the assets lost by banks.

However, this creates a problem known as the “moral hazard.” If banks know that the FDIC will always cover them, the bank can take bigger risks without worrying about consequences. Even if it loses all of its customer’s money, the FDIC will pick up the tab.

Just saying “we will not bail out banks” means that the next minor panic will lead to a major bank run. This strategy, called “Liquidationalism,” was followed by Hoover at the start of the Depression. Roosevelt’s FDIC took the other extreme by saying “we will always bail out banks.”

RAFSA offers a compromise between bail-outs and Liquidationalism. If a company undergoes some event which makes it insolvent and beyond any other form of assistance, the FDIC would help “unwind” systematically significant companies so that there is no psychological panic. The moral hazard diminishes since companies taking excessive risks stand to lose, while the psychological shockwaves of the bankruptcy of a “too big to fail” company are dampened by FDIC intervention. This liquidation system was going to be paid for by a $50 billion fund from the largest financial companies. This is the $50 billion that Mitch McConnell called a “bail out fund.”

Unlike the 1930s, “too big to fail” now extends beyond banks. The debate took a turn starting in the late 20th century when Congress pushed to repeal regulations which stopped banks from taking excessive risks through non-banking functions like those taken by hedge funds. Since the passage of the Glass-Steagall Act in 1932, only commercial banks were allowed to engage in banking activity like deposits and checking accounts. Investment banks, such as hedge funds, dealt with capital market activities, an extremely complex and risky industry involving derivatives such as Credit Default Swaps and Collateralized Debt Obligations. Even worse, as banks became larger, the increased assets made it harder for the FDIC to have the funds to cover a possible bank run.

In the late 1990s, congressional Republicans, followed closely by Democrats, pushed for the repeal of Glass-Steagall Act. Now, investment banks such as Lehrman Brothers could take on commercial bank activities such as deposits without commercial bank regulation. This allowed for more risk and thus higher pay-offs. These non-bank institutions make up the “shadow banking system” which Nobel prize winning economist Paul Krugman considers the major cause of the crisis.

Normally, derivatives such as Credit Default Swaps are an effective way of spreading risk. However, without regulation or transparency, it soon becomes nearly impossible to price these vague financial tools. The only immediately available information is the face value of the derivative. The inability to calculate the true risk from derivatives helped form and aggregate “toxic assets” in commercial and investment banks. “Toxic assets” are financial products for which there is no functioning market. If a buyer and seller are unable to price the financial product, neither are willing to trade. Toxic assets also form when a financial product is entirely worthless, such as an product whose value comes from collecting debt from a party that has defaulted. These toxic assets were the key government purchase in the AIG bail out. It should be noted that the creation of opaquely priced toxic assets was greatly aided by Fannie Mae and Freddie Mac’s habit of chopping individual mortgages into securities which, when hit with a sub-prime loaning crisis, became worthless and/or unpriceable.

While the unregulated nature of the derivatives market makes it hard to estimate the capital involved, according to the Bank of International Settlements, in June of 2004 the total face value of all derivatives was $220 trillion. By the end of 2007, unregulated derivative markets totaled $596 trillion. In comparison, the entire U.S. Debt is around $13 trillion dollars, a little more than 2%.

RAFSA fights trends towards toxic assets and unregulated derivatives by using policies championed by both liberals and conservatives. The Volcker Rule, named after deficit hawk and Federal Reserve Chairman under Reagan Paul Volcker, limits the ability of commercial banks to invest their customer’s assets into investment banks. At the same time, as commercial banks increase in size, the new Financial Oversight Committee (FOC), a team of regulators within the Federal Reserve, can adjust the amount of “insurance,” such as capital requirements, a bank posing systematic risk to the financial system must have. This discourages “too big to fail” while making large banks lower the risk they pass on to customers. The FOC also allows the government to impose commercial banking regulations on shadow banks. Likewise, now hedge funds must register with the SEC as investment advisors who must, like all other investment advisors, divulge information about their trades. It gives the government the chance to address systematic risks from “too big too fail” companies before the next crisis.

When it comes to Credit Default Swaps and other derivatives, RAFSA legislates that trades must go through a clearinghouse just like stocks on the stock market. This stops the formation of “toxic assets” through opaque pricing. It also means that banks are less likely to over-expose themselves to risk from derivatives. It gives the Federal Reserve the ability to regulate such newly invented financial tools before they cause havoc. Also, companies that sell financial products such as mortgage-backed securities must retain at least 5% of the credit risk, incentivizing companies to not take gamble with consumer funds. This diminishes the moral hazard related to companies not losing out from bankrupting their customers.

However, the Federal Reserve is not just part of the solution. The director of the Federal Reserve Board may be voted for by people connected to a company regulated by the Federal Reserve. Member banks elect directors who choose the Federal Reserve Board President. RAFSA stops this conflict of interest by prohibiting individuals, subsidiaries, or companies from voting for director of the Federal Reserve if they are regulated by the Federal Reserve.

While there are some details to quibble about, Republicans and Democrats know that the core of the Restore American Financial Stability Act of 2010 is a large step towards stopping a re-run of both the Great Depression and Great Recession. It takes a middle road between extremist “let ‘em burn” Liquidationalism and “always bail ‘em” Keynesian orthodoxy. Companies posing systematic risk to the financial system will be “liquidated” in a calm and smooth manner so as to prevent bank runs. The FDIC can still get funds from the Treasury department in order to help debt guarantees for customers of solvent banks, but now those funds can only go towards working capital and must be repaid in assets after liquidation. RAFSA also finally gives the government a foot in the door when it comes to regulating shadow banks and dangerously opaque derivative transactions.

Unfortunately, the obstructionism of Senate Republicans has already dealt a blow to reform. Recall that, in order to stop tax payers from paying for the $50 billion liquidation fund, large financial firms must contribute to these “funeral insurance plans.” Republicans are framing this as a burden to taxpayers. If the Republicans have their way, the liquidation fund will be paid by loans from taxpayers, not financial companies. The CBO now estimates that this move by Republicans would turn the financial bill from a deficit-saving measure to an addition to the deficit. Expect Congressional Republicans to attack the financial bill for adding to the deficit. At the very least, assuming they have their way, it won’t be a lie.

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