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July 17, 2010

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What Problems were Solved by Financial Reform Legislation?

Posted: 17 Jul 2010 01:17 AM PDT

I was on a conference call this morning with Michael Barr, the Assistant Treasury Secretary for Financial Institutions, talking about the Wall Street reform bill. His remarks on Elizabeth Warren have already been well covered elsewhere, so I want to focus on his remarks about the legislation itself.

The call opened with his summary of the most important things in the bill, and then we were allowed to ask questions. In his opening remarks, the first thing Barr mentioned was that the legislation would end the too big to fail problem. So I wanted to ask him:

What does Treasury see as the one or two biggest problems in the financial sector that contributed to the crisis, and how does this legislation solve those problems?
More specifically, would it be fair to say that Treasury views the TBTF problem as the most important problem that needs to be solved in the financial sector? Is it also fair to say that the legislation has everything Treasury requested to deal with this problem?

Unfortunately, in another episode of "the dumb things I do," I hit #1 instead of *1 (twice after it didn't work on the first round of questions) so I didn't get my question in the queue. Next thing I knew, the call was over. I had sent an email asking for the right code during the call (even though I was the problem, I knew it was *1 but kept punching the wrong buttons). I was told later to submit the question by email, but haven't received a reply.

I hope I do get an answer so I can confirm this: Too big to fail was the main emphasis of the initial presentation, and I got the impression that this was, in fact, the main problem that Treasury thought needed to be solved. Further, from the triumphant nature of the presentation and what was said about how the legislation coincided with the Treasury reform proposal that was put out some time ago, I also got the impression that Treasury believes it got everything it asked for to solve the too big to fail problem.

Regulators believe they now have the authority to force troubled banks into a resolution process, something they didn't  have before, and that they can do so in a way that won't disrupt the banking sector and create even bigger problems. But regulators won't know if this will actually work until they try it, and that's the problem. When it comes time to try this for the first time on a financial sector teetering on the edge, will regulators be willing to risk endangering the entire system to try this out? Regulators are not going to let the system crash on their watch if they can help it, and if that means abandoning resolution plans in the heat of the moment, they won't hesitate to do so.

My view is that we should expect that bailouts will occur, and that firms understand this (or at least give this outcome a meaningful probability in their risk assessments). That gives financial institutions operating under this type of implicit guarantee an advantage over other firms, and it encourages the build-up of excessive risk. Maybe resolution authority will work, and I hope it does, but we should assume that it may not work and take the appropriate precautions, one of which is strict regulations on the amount of risk firms can take on. Unfortunately, the legislation does not do enough to limit risk-taking, particularly -- though not exclusively -- its failure to place adequate limits on leverage.

"Political Aspects of Full Employment"

Posted: 17 Jul 2010 01:08 AM PDT

Via email, everything old is new again. This is from 1943:

Political Aspects of Full Employment, by Political Quarterly, 1943: ... Section IV ... 3. ...In the slump, either under the pressure of the masses, or even without it, public investment financed by borrowing will be undertaken to prevent large-scale unemployment. But if attempts are made to apply this method in order to maintain the high level of employment reached in the subsequent boom, strong opposition by business leaders is likely to be encountered. ...
In this situation a powerful alliance is likely to be formed between big business and rentier interests, and they would probably find more than one economist to declare that the situation was manifestly unsound. The pressure of all these forces, and in particular of big business—as a rule influential in government departments—would most probably induce the government to return to the orthodox policy of cutting down the budget deficit. A slump would follow...
This pattern of a political business cycle is not entirely conjectural; something very similar happened in the USA in 1937-8. The breakdown of the boom in the second half of 1937 was actually due to the drastic reduction of the budget deficit. ... [full text]

links for 2010-07-16

Posted: 16 Jul 2010 11:03 PM PDT

"In Finance We Distrust"

Posted: 16 Jul 2010 11:16 AM PDT

One more before I hit the road to my high school class reunion (35 years):

In Finance We Distrust, by Michael Spence, Commentary, Project Syndicate: Around the world,, the debate about financial regulation is coming to a head. ...
It now seems universally accepted (often implicitly) that government should establish the structure and rules for the financial system, with participants then pursuing their self-interest within that framework. If the framework is right, the system will perform well. The rules bear the burden of ensuring the collective social interest in the system's stability, efficiency, and fairness.
But in a complex system in which expertise, insight, and real-time information are not concentrated in one place, and certainly not in government and regulatory circles, reliance on such a framework seems deficient and unwise. Moreover, it ignores the importance of trust. A better starting point, I believe, is the notion of shared responsibility for the stability of the system and its social benefits – shared, that is, by participants and regulators.
It is striking that no senior executive of whom I am aware has laid out in any detail how his or her institution's expertise could be deployed in pursuit of the collective goal of stability. The suspicion that underlies much of today's public anger is that these institutions, having influenced the formulation of the legal and ethical rules, could do more to contribute to stability than just obey them.
The finance industry, regulators, and political leaders need to create a shared sense of collective responsibility for the system as a whole and its impact on the rest of the economy. This set of values should be deeply embedded in the industry – and thus should transcend haggling over regulation. It should take precedence over narrow self-interest or the potential profit opportunities associated with exploiting an informational advantage. And it should be thought of as an addition to the guiding norms, rules, and ethics associated with "normal" times.
Some will object that this idea won't work because it runs counter to greedy human nature. Yet such values shape other professions. In medicine, there is a huge and unbridgeable gap in expertise and information between doctors and patients. The potential for abuse is enormous. It is limited by professional values that are inculcated throughout doctors' training, and which are bolstered by a quiet form of peer review.
By itself, such a shift in values and the implicit model that defines roles certainly will not solve the challenge of systemic risk. Neither will fiddling with the rules. Taken seriously, however, it could help provide an ongoing reminder of the importance of the financial sector to the broader well-being of the economy. It might even help start rebuilding trust.

In medicine, I think it's regulation, not professional ethics that prevents the most blatant types of snake oil treatments and other means of exploiting consumers. If there is lots and lots of money to be made selling the latest cure for baldness, acne, wrinkles, whatever, some doctor will step in and sell the treatment whether it works or not. And ethical standards do not seem to stop conflicts of interest such as doctors owning testing centers, and then having a tendency to order more tests than necessary at those facilities. To the extent that this has been prevented, it's been due to government intervention, not shared ethics.

In general, it's the threat of loss of license and lawsuits, not condemnation from peers, that is the real constraint on behavior for those lacking the conscience that might stop them from engaging in such practices. If there were no regulations to prevent it, then any snake oil treatment that proved highly profitable would be quickly adopted and mimicked by others with a medical license but lacking the ethics that are supposed to come with it. In the end, it's the government's ability to take away a medical license that prevents doctors from, say, charging $250 for an office visit that is all but guaranteed to result in a medical marijuana card (and even with such a threat, such doctors exist, at least in Oregon). Without that fear, ethics alone would not be enough. The ethical standards must be backed by a hammer, and for doctors that is their license to practice. I don't mean to condemn all doctors as lacking such ethics, or even most, not at all. This isn't needed in most cases. But it only takes a few who are willing to ignore ethical standards to undermine the system.

That is the problem with this approach. If there is a way to make a profit and no penalty for pursuing it other than peers shaking a finger at you and saying what a rotten person you are, then somebody will step in and take the opportunity to get wealthy. If there are millions to be made, the shaking fingers are tolerable and others will surely follow suit. If there is no hammer that comes down and imposes a penalty when people engage in such behavior, then there will always be those who are wiling to take the money over their reputations.

With that said, however, I still think there is something to be gained by having such ethical standards in place. Norms for appropriate behavior are important, and they can constrain some behavior. But we shouldn't rely too much upon them, or hope that they can somehow substitute for regulation with teeth. Because ethics without strong penalties for violating them won't do much to constrain highly profitable schemes that separate people from their money, and government is best suited to enforce these types of rules and regulations, i.e. to provide the teeth. We can hope the private sector will do this on its own through professional societies and the like, and that when these societies condemn a person or practice it will have an effect. But these organizations often turn into ways for the industry to protect itself against new entrants -- it becomes a way for industry insiders to protect themselves rather than a way of protecting the public -- and the penalties they impose don't mean much if there is no law or regulation to prevent the behavior they condemn. So I hope we don't make the mistake of thinking that we can rely upon the private sector to suddenly find ethics that weren't there before and fix these kinds of problems on its own. Again, ethics are useful and they should go as far as they can, but I think a strong set of rules and regulators who are ready and willing to enforce them are the real key to fixing these kinds of problems.

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