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How Chris Dodd's FinReg proposal solves the problem of information, but not of regulators

dodfinreg.JPG

Consider this: Regulators such as the Federal Reserve had 48 hours of warning before the fall of AIG. They had 72 hours before the collapse of Bear Stearns. The system's most powerful watchdogs had no idea that the most dangerous firms were ticking time bombs. And as we know, when the bombs went off, they had no idea what to do. Chris Dodd's financial-regulation proposal (pdf) is an effort to make sure they're never caught unaware, or unprepared, again.

Insofar as Dodd's proposal has a clear theory of the case and its solution, it's this: At every point in the chain of events that led to the financial crisis, there was a crucial information deficit. Consumers didn't understand the products they were buying. Regulators didn't understand the banks they were regulating (and, in some cases, not regulating). There were non-bank players such as AIG that had become central to the system but that few were watching. And no one understood what to do when the banks collapsed. At the most basic level, Dodd's bill is an effort to make sure the absence of information never leads to a financial crisis again. The question is whether that's enough.

It's easy to forget that the financial crisis began with one subprime mortgage, sold to one consumer, at a time. That's the argument behind the Consumer Financial Products Bureau. Housed in the Federal Reserve (a significant defeat for advocates), the CFPB will be run by a presidential appointee, funded through a dedicated budget, and empowered to write new rules on its own. Supporters of the initiative -- including Elizabeth Warren, who first came up with the idea -- believe that Dodd's bill retains the CFPB's independence. They worry, however, that housing it in the Federal Reserve means it's only one amendment away from becoming a servant of the Federal Reserve -- and the Fed has a terrible track record regulating consumer products.

If it survives, the point of the CFPB, as one supporter explains it, is to "make contracts comprehensible again." That's it. No one expects it to have the power to force companies to offer so-called "plain vanilla" products. But if it can bring contracts down to two pages from 10; if it can standardize how these products are presented so people can make informed decisions; if it can end the "teaser culture" in which the low initial costs are in bold letters and the dangers are confined to a jargon-filled footnote on page 6; maybe it can do some good.

But that's a lot of "ifs," and I should admit my skepticism: Would more prominent disclosure of prepayment penalties and interest hikes have averted the subprime crisis? How do we keep individual brokers from de-emphasizing them?

What might have averted the crisis was regulators who recognized not only the building pressure on bank balance sheets, but the risk that individual firms posed to the entire system. That will be the job of the Financial Stability Oversight Council. The FSOC -- which is really fun to say aloud, incidentally -- will be made up of nine federal regulators, one independent appointee, and chaired by the secretary of the Treasury. It will be staffed by a new Office of Financial Research inside the Treasury Department that'll be, at base, a data-gathering operation.

The FSOC -- "fff-SOK!" -- will be charged with watching banks (think Bank of America) and non-bank actors (think AIG) of systemic importance and making recommendations about what the Federal Reserve should do with them. The council can recommend "increasingly strict rules for capital, leverage, liquidity, risk management." It can bring non-bank entities under the Federal Reserve's regulatory umbrella. Working with the Federal Reserve, it can break up systemically dangerous institutions, or force them to divest themselves of holdings or end certain business practices. But a lot of this is dependent on not just the council's decisions but on the Federal Reserve's agreement.

If all works well, the FSOC will alert regulators to problems in systemically important institutions before they threaten to consume the host. But if not, the bill creates an orderly process the FDIC can use to shut down failing institutions. In it, shareholders and unsecured creditors bear losses and management loses their jobs. It also gives them a roadmap for how to do it: Systemically important institutions will have to produce so-called "funeral plans" laying out exactly how they could be shut down if it came to that. No more late-night confusion at the Federal Reserve.

And one important proviso to all of this: The derivatives section in the proposal is not the one that will be in Dodd's final bill. It's a placeholder for the derivative-regulation package that Judd Gregg and Jack Reed are working to build. But unless there's transparency in derivatives, there can't be transparency in balance sheets. "Derivatives reform is intimately tied to the functioning of the entire system," says the Roosevelt Institution's Rob Johnson, a former chief economist for the Senate Banking Committee. "If derivatives reform is done well, it creates clarity in how much capital a firm has and whether they’re impaired or not. In the absence of derivatives reform, everything remains muddy. A lot will live or die around that point."

But assume the derivatives piece comes out okay. This, then, is the core of the bill. Regulators get more and better information and more and better powers. The question is whether that's a good theory for this legislation. And I don't think it is.

One of the lessons of the financial crisis is that you can lead a regulator to information, but you can't make him drink. Imagine a world in which Alan Greenspan helms the Federal Reserve, in which George W. Bush appoints the Treasury Secretary, and in which the consensus is that the data showing we've abandoned historical economic trends are explained away because the sophisticated new products that few understand have effectively hedged away the risks. If that sounds familiar, it should. We're living through the aftermath. And if there's anything this bill should protect against, it's the factors that led to the most recent crisis.

But this bill gives those failed regulators more power and autonomy, not less. It deals with the information that they didn't have and it deals with the authority they didn't have, but it doesn't deal with their failure to want to regulate. "If you had omniscient, courageous regulators who experience no feedback, disapproval, negative press, or anger from powerful people, they could make this work," says Johnson. But we don't.

The alternative to relying on regulators would have been laying down automatic protections. Consider FDIC deposit insurance: It doesn't matter whether Ben Bernanke thinks Bank of America is doing a good job, or whether Bank of America makes a case that they can protect consumers another way. The insurance is simply there. It's one of the rules of the road. And we haven't had a serious bank run since its inception.

Conversely, this bill doesn't set, say, any specific capital requirements. Dodd isn't saying that banks with assets over $500 billion, or banks that are ruled systemically important, are limited to a 15:1 debt-to-capital ratio. That leaves the possibility that regulators will decide not to impose sufficient capital requirements when they're caught up in the next boom cycle.

Dodd's argument is that Congress should not micromanage the financial sector. But the problem isn't an abundance of micromanagement, but an absence of macromanagement. In bubble times, regulators have bubble mindsets. We who've just experienced the pain of a burst need to lay down some rules that'll hold even when irrational exuberance comes back for another visit.

The FDIC example brings up another point: After the Great Depression, we changed the banking market such that the problem that created the financial crisis (mistrust in banks leading to bank runs) would never happen again. We're not doing that here. "There isn’t any real structural change to the finance sector," says Demos's Heather McGhee. "It is so vastly different from what it was even 10 years ago, with most of the funding for financial firms coming from bizarre, complicated capital market products that are very attenuated from real sources of funding. But it’s all untouched."

Dodd, of course, is working in a 60-vote environment, not a land of his own imagination. So the bill is a compromise with political realities, and it will be compromised further still. Which is a scary prospect. Because at some point, this thing either works or it doesn't. As it stands, the bill seems like a very good thing for regulators who know they're in a financial crisis, and the new institutions meant to watch systemic risk and gather information may help regulators realize when they're headed in that direction. But if they don't -- and history suggests that they won't -- this bill does very little to protect us in their absence.

To put it another way, regulators would have been better off if this bill had passed before they had to respond to the financial crisis, but it's hard to say that the presence of this bill would have prevented the crisis.

Photo credit: By Andrew Harrer/Bloomberg

By Ezra Klein  |  March 16, 2010; 6:30 PM ET
Categories:  Financial Regulation  
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Next: Reconciliation

Comments

"If it survives, the point of the CFPB, as one supporter explains it, is to "make contracts comprehensible again." That's it. No one expects it to have the power to force companies to offer so-called "plain vanilla" products. But if it can bring contracts down to two pages from 10; if it can standardize how these products are presented so people can make informed decisions"

Not for nothing but if you're buying a home and can't read 10 pages or understand 10 pages maybe you shouldn't be buying a home.

Exactly how do you expect to "enforce" how they're presented?

I understand you can't have unscrupulous mortgage bankers trying to make a quick buck but you also have to have new homeowners that buy within their means and stay there.

As you state regulation's been there (but not to this extent) but they have to WANT TO regulate.

Posted by: visionbrkr | March 16, 2010 7:10 PM | Report abuse

Excellent piece, Ezra. But this:

"the bill creates an orderly process the FDIC can use to shut down failing institutions. In it, shareholders and unsecured creditors bear losses and management loses their jobs."

The FDIC already does this, all the time, doesn't it? What would this bill change about this function of the FDIC?

Posted by: thehersch | March 16, 2010 7:40 PM | Report abuse

yes, nice job of work Ezra. Macro management indeed. It was at the macro level that the system collapsed.

I don't think we need to worry too much about people buying homes within their means, for example - it was the credit industry itself that deliberately enlarged those means. This proceeded from a systemic culture of arbitrage that could tolerate no slowdowns or limits to growth, by hook or by crook.

That culture is still reflected today in the $60 trillion of derivatives at large in the global economy, a sum roughly equal to the productive global economy itself.

The world of course can't call in this kind of gambling marker, not when the world itself is the stake. All we can do is plug the little holes that appear (using real wealth) as various players have fainting spells. Occasionally a lone player is carried to the bench.

What we need - exactly as one could infer from your scepticism - is hard-coded laws that mandate the macro percentages of risk and collateral and segregate the instruments and the industries beyond discretionary choice.

Then we could use something like the FBI to handle the regulation.

So the problem to be addressed lives at the macro political end of things, and this requires a large swell of public awareness coupled with some legislators who haven't been too badly bought. I have great faith in the first, but the second? There's that rub again.

Posted by: rosshunter | March 16, 2010 9:45 PM | Report abuse

--"Regulators such as the Federal Reserve had 48 hours of warning before the fall of AIG. They had 72 hours before the collapse of Bear Stearns. The system's most powerful watchdogs had no idea that the most dangerous firms were ticking time bombs. And as we know, when the bombs went off, they had no idea what to do."--

Well, it was none of their business anyway, and piling on more stupid laws still won't make it any of their business.

And it's none of your business, Klein.

Go run your own insurance co/bank or whatever if you want to, but keep your stupid nose out of everyone else's biz. You're like a reeking old washer woman, worried about everyone except your own reeking self.

Posted by: msoja | March 16, 2010 11:38 PM | Report abuse

Ezra I trust you read Simon Johnson. Here's some pertinent commentary from over there to add to this discussion:

"Who is Senator Kaufman and what power does he have in this situation? He is not a member of the Senate Banking Committee – and if you think this is a regulatory issue, that reduces the weight of his voice.

"But he is a member of the Senate Judiciary Committee and we are discussing here potential crimes – or what should be crimes if the legal system still functioned. He was also a cosponsor of the Fraud Enforcement and Recovery Act (FERA) – which was right on topic – and is an experienced Capitol Hill insider who has studied these issues long and hard. He has also worked closely, over many years, with Vice President Biden.

"The tide is turning, but not primarily through the actions of Senator Dodd and his Banking colleagues. Rather the biggest and most unruly players in our financial system have behaved in such an egregious manner that they will be brought down by the law – either that, or they will further bring down the law."

Link is:
http://baselinescenario.com/2010/03/15/senator-kaufman-fraud-still-at-the-heart-of-wall-street

Posted by: rosshunter | March 16, 2010 11:44 PM | Report abuse

Ah, now that HCR is finally about to be born, or laid to rest, glad to see you're turning to Finance Reform.

I second rosshunter's pointer to baselinescenario.com (for anyone who's interested) and would add Rortybomb (Mike Konzcal) to that. Both sites have excellent information about the meltdown, its causes, and what needs to be done.

Baseline guys are none to thrilled with Dodd's proposal, think it's weak and misses critical issues, and placing the CFPA at Fed is laughable, like putting one red consumer hot-line phone in the basement of the Fed building.

Rortybomb cleverly decided it would be more instructive to compare Dodd's proposal to a Fin Reform package created by Rs rather than the House version. Sure 'nough, very similar. Once again, we get watered-down legislation to appease some Rs, but no R-votes in exchange. This is really getting old.

Posted by: onewing1 | March 17, 2010 5:29 AM | Report abuse

"Consider FDIC deposit insurance: It doesn't matter whether Ben Bernanke thinks ..."

1. When did Bernanke go to work for the FDIC?

2. Admit it -- you know next to nothing about how the FDIC operates. Before you opine at length on bank regulation, perhaps you ought to learn something about it.

Posted by: ostap666 | March 17, 2010 8:33 AM | Report abuse

Michael Hirsch makes the following point about derivatives: "What needs to be addressed is not so much what kind of products are out there but the way they are traded. The real mischief occurs when credit default swaps and other arcane derivatives are privately negotiated out of sight of regulators."

Posted by: jduptonma | March 17, 2010 8:41 AM | Report abuse

rosshunter,

Ya because people didn't take out 2nd and third mortgages to try to "keep up with the Jonses". That didn't happen???

Sure the rest of what you say is correct but disputing my point show you only want to pass blame to industry and not to everyone responsible.

Posted by: visionbrkr | March 17, 2010 9:25 AM | Report abuse

No matter how good a regulatory or legal regime is, financiers will eventually figure out a way to cheat on it. That's their job. (For example, the FDIC meant we haven't have a lot of bank runs, but it only took until the 1970s for troubled bankers to realize that they could attract billions in new deposits with higher interest rates and then let the FDIC pick up the pieces if their gambles failed.)

So we need both law and regulation, but we also need a framework for laws and regulations to co-evolve with the latest financial "innovations". And some kind of career path so that joining the other team isn't the only way for a regulator to ensure a comfortable retirement.

Posted by: paul314 | March 17, 2010 9:57 AM | Report abuse

It also might help to have a culture in which so many people didn't measure their worth in financial terms and compete to be the biggest, in which morality, in addition to the law, was some kind of check on greed.

But we don't have that, and as long as these predators are celebrated and excused, the rest of society will suffer.

Posted by: Mimikatz | March 17, 2010 11:42 AM | Report abuse

Giving derivatives the same sensible regulations that all other traded financial products have would solve a lot of the information imbalances:

http://www.ritholtz.com/blog/2010/03/time-to-regulate-derivatives/

Posted by: scott_teresi | March 17, 2010 12:33 PM | Report abuse

Christopher Dodd's proposal defies the laws of logic:

http://reshapingmisconceptions.blogspot.com/2010/03/how-big-is-too-big.html

Posted by: ais000 | March 20, 2010 1:21 AM | Report abuse

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