Misnamed Financial Services "Reform" Bill....Systemic Risk Is Alive and Well"

[amborin]

Misnamed Financial Services “Reform” Bill Passes, Systemic Risk is Alive and Well


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what does the bill accomplish? It inconveniences banks around the margin while failing to reduce the odds of a recurrence of a major financial crisis.
The only two measures I see as genuine accomplishments, the Audit the Fed provisions, and the creation of a consumer financial product bureau, do not address systemic risks.
And the consumer protection authority was substantially watered down. Recall a crucial provision, that banks be required to offer plain vanilla variants of products, was axed early on.
In addition, the agency, initially envisioned as independent, will now be housed in the Fed, which has never taken any interest in consumers (witness its failure to enforce the Home Owners Equity Protection Act, a rule which would have limited subprime lending) and has a long standing hands-off posture towards its charges.

Most of the rest is mere window dressing. The Volcker Rule was substantially watered down. Banks can still own private equity and hedge funds so long as they do not exceed 3% of core capital. There is no justification, nada, for organizations enjoying state guarantees to engage in anything other than socially useful activities that cannot be readily provided by outside players. Nevertheless, Goldman may have to reduce its PE and hedge fund exposure by as much as $10 billion, and Morgan Stanley, $3 billion. While there are purported to be limits on proprietary trading, the latest state of play was to designate transactions with customers as not being prop trades, an absurd definition given the intent of the provision (I must confess I have not seen the final language, so any reader input here would be appreaciated).

From a systemic risk standpoint, the two most important things that needed to happen were greatly increased equity levels (this would need to take place gradually) and a reduction in the “tight coupling” of the major capital markets firms. Right now, the top dealer firms are part of a badly designed network, where if one node goes down, it can bring down the entire grid. Neither was tackled in a serious way.

The most important two products to address in term of the excessive interconnectedness of financial firms were repos and credit default swaps. The New York Fed has been soldiering along on repo, yet is unconvinced of the effectiveness of its changes (!); the Blanche Lincoln amendment got reworked into putting the riskiest derivatives, including CDS, into a separately capitalized operation. Since (as we have discussed at length) CDS are not economic if adequately margined/capitalized, this measure does almost nothing to defuse the CDS bomb (the same problem exists even if the CDS are cleared centrally, which means the clearing organization becomes a potential AIG, a mere concentrated point of failure. ...

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A sampling of comments on the bill:

From Michael Hirsh of Newsweek:

“Financial Reform Makes Biggest Banks Stronger“

Dodd-Frank effectively anoints the existing banking elite. The bill makes it likely that they will be the future giants of banking as well. Legislators touted changes that would restrict proprietary trading by banks and force them to spin off their swaps desks into separately capitalized operations. But banks get to keep the biggest part of their derivatives business, which is dominated by interest-rate and foreign-exchange swaps. Some 80 to 90 percent of that business will remain within the banks, and J.P. Morgan, Goldman Sachs, Citigroup, Bank of America, and Morgan Stanley control more than 95 percent, or about $200 trillion worth of that market. These same banks may end up controlling or at least dominating the clearinghouses they are being pressed to trade on as well, since language proposed by Rep. Stephen Lynch, D-Mass., to limit their ownership stakes to 20 percent, was dropped in the final version of the bill, according to Lynch’s spokeswoman, Meaghan Maher. “No numerical limitations were set; regulators were given the ability to do so,” she said.

The bill leaves many other future decisions, for example on pay structure and incentives, to regulators as well. “The bottom line: this doesn’t fundamentally change the way the banking industry works,” says a former U.S. Treasury official who has followed the legislation closely but would give his judgment only on condition of anonymity. “The ironic thing is that the biggest banks that took the most money end up with the most beneficial position, and the regulators that failed to stop them in first place get even more power and discretion.”

From Marshall Auerback:

The whole approach to financial reform has failed to deal with the core problems with gave rise to the crisis in the first place. Credit default swaps, collaterised debt obligations, etc., need to be understood as key components of an integrated system, the so-called “shadow banking system”, which was at the epicenter of the crisis…..

As Jan Kregel has noted…“the liquidity crises in 1998 and 2008 produced, not a run on banks, but a collapse of security values and insolvency in the securitized structures, and the withdrawal of short-term funding from the shadow banks. The safety net created to respond to a run on bank deposits was totally inadequate to respond to a capital market liquidity crisis.”

The new “financial reform” bill merely reflects the model of a banking structure which was already largely gone by the time we abolished Glass-Steagall. The proposed bill fails to recognise that in a capital market-based credit system, the key player is not the bank that originates and holds the loan, but rather the dealer who makes liquid markets in the security into which the loan is bundled. In such a system, the focus of regulation should not be on the capitalization and liquidity of banks per se, but rather on the capitalization and liquidity of dealers….
Ideally, systemically risk products such as credit default swaps should be abolished, as they serve no public purpose. But this is impossible in the real world. Pandora’s Box has been opened and can’t be shut again.
The problem with today’s reform is that sellers of credit default swaps without an adequate capital cushion may be required to post collateral on an exchange, which raises the question, “How much collateral is enough?” AIG clearly didn’t have enough. Potentially, no private financial institution does…
We should also impose greater regulatory oversight on the products emerging from this capital based market system. There is no reason why the SEC could not rescind rule 3a-7, which has exempted securitised structures from registration and regulation under the Investment Companies Act. This rescission would functionally act like a Tobin tax insofar as the resulting higher regulatory thresholds would likely slow down the proliferation of new securitised products, as well as imposing a great fiduciary responsibility on the issuer.

From Bill Black:

The fundamental problem with the financial reform bill is that it would not have prevented the current crisis and it will not prevent future crises because it does not address the reason the world is suffering recurrent, intensifying crises. A witches’ brew of deregulation, desupervision, regulatory black holes and perverse executive and professional compensation has created an intensely criminogenic environment that produces epidemics of accounting control fraud that hyper-inflate financial bubbles and cause economic crises. The bill continues unlawful, unprincipled, and dangerous policy of allowing systemically dangerous institutions (SDIs) to play by special rules even when they are insolvent. Indeed, the bill makes a variety of accounting control fraud lawful. The financial industry, with Bernanke’s support, already got Congress to extort FASB to gimmick the accounting rules so that insolvent banks could hide their losses and continue to pay the executives (already made rich by destroying “their” firms — that’s the meaning of Akerlof & Romer’s classic article: “Looting: Bankruptcy for Profit”) massive bonuses. All of this is made possible by huge, off budget subsidies to the SDIs via the Fed and Fannie and Freddie.

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http://www.nakedcapitalism.com/2010/06/misnamed-financial-services-reform-bill-passes-systemic-risk-is-alive-and-well.html

[Rex]

1. Look, they are all crooks and found a way to rob the vault without

going to prison...don't think for a minute they are about to fix that kind of loophole. I'm still surprised we got habeas corpus back as soon as we did, but we can now be assassinated (domestically) so it really amounts to nothing.

[branders seine]

2. But the name allows Obama to add it to his list of 'accomplishments'

and pretend it's a victory.

[katandmoon]

3. Yup! Right up there next to the health insurance company giveaway!

[branders seine]

4. and economic 'stimulus'

[jp11]

7. but it is a victory

we have changed the game,
wall street now fears the guberment
you need to turn on your tv or read a paper

:sarcasm:

[leveymg]

5. Systemic risk? Pangloss Effect? Market Failure? "What, me worry?"

They are The Masters of the Universe - who are we to try to clip their wings of fire.

[ProSense]

6. Interesting argument

Yves here. This is simply arch. To appreciate the significance of the comparison to the 1999 Glass Steagall repeal, you first need to compare it to the PR in the US press, which touts the bill as the most sweeping reform since the Great Depression. The FT isn’t buying the hype. Moreover, the Glass Stegall repeal was even less significant than the headlines then or more recent commentary would suggest. Why? By 1999, Glass Steagall was so shot full of holes with all the regulatory variances that Glass Steagall was close to a dead letter. Banks had been obtaining variances since the 1980s. By the mid 1990s, securities firms were making bridge loans and the biggest banks were increasingly influential in derivatives, stock, and bond underwriting.

So the repeal of Glass-Steagall had nothing to do with the crisis?

Auerback:

The new “financial reform” bill merely reflects the model of a banking structure which was already largely gone by the time we abolished Glass-Steagall. The proposed bill fails to recognise that in a capital market-based credit system, the key player is not the bank that originates and holds the loan, but rather the dealer who makes liquid markets in the security into which the loan is bundled. In such a system, the focus of regulation should not be on the capitalization and liquidity of banks per se, but rather on the capitalization and liquidity of dealers….

Ideally, systemically risk products such as credit default swaps should be abolished, as they serve no public purpose. But this is impossible in the real world. Pandora’s Box has been opened and can’t be shut again.

This is the premise of most of the criticism of the bill, which essentially confirms that the bill is a return to pre Glass-Steagall structure.

In fact, the repeal of Glass-Steagall had everything to do with the crisis. Arguing about the systemic risks associated with banks is overlooking that fact. Banks have always been big, it the shawdow practices in the wake of the repeal that caused the problem.