Put the Banks Back in Their Regulatory Box or They Will Bankrupt Us All

President Obama’s speech yesterday was disappointing. As a diagnosis of the problems that let us into financial crisis, it was his clearest and best effort so far. He didn’t say it was a rare accident for which no one is to blame; rather he placed the blame squarely on the structure, incentives, and actions of Wall Street.

But then he said: our regulatory reforms will fix that. This is hard to believe. And even the President seems to have his doubts, because he added a plea that – in the meantime – the financial sector should behave better.

The audience was comprised of our financial elite, but the Wall Street Journal reports “not one CEO from a top U.S. bank was in attendance” (p.A4). How’s that for demonstrating respect, gratitude, and a willingness to behave better?

Louis Brandeis, of course, would have seen things differently. The author of “Other People’s Money: And How The Bankers Use It,” was under no illusions concerning the underlying financial power structures and how they operated. He would have regarded an appeal to the better nature of bankers as somewhere between humorous and sad.

The only thing that will make a different is regulation. This is the lesson of the 1930s in the US – the regulations imposed at that time created a financial sector that did not impede growth after World War II; basic intermediation (connecting savers and borrowers) worked fine and destabilizing frenzies were avoided. During this period, the financial sector came up with venture capital, ATMs, and credit cards – arguably the three most important financial innovations of the past 100 years, and much more helpful of real innovation than anything you’ve seen since 1980.

President Obama claimed that three regulatory proposals will make the system safer.

“First, we’re proposing new rules to protect consumers and a new Consumer Financial Protection Agency to enforce those rules.” This is a very good thing, and of course the banks are adamantly opposed. But this Agency will not by itself bring us financial stability; that requires change at the level of how banks and other financial institutions are operated.

Second, he talked about “gaps in regulation”; this is international finance bureaucrat code for mush (doesn’t the President know this?). The specific potentially interesting pieces he put under this heading were run together in this paragraph,

“While holding the Federal Reserve fully accountable for regulation of the largest, most interconnected firms, we’ll create an oversight council to bring together regulators from across markets to share information, to identify gaps in regulation, and to tackle issues that don’t fit neatly into an organizational chart. We’ll also require these financial firms to meet stronger capital and liquidity requirements and observe greater constraints on their risky behavior. That’s one of the lessons of the past year. The only way to avoid a crisis of this magnitude is to ensure that large firms can’t take risks that threaten our entire financial system, and to make sure they have the resources to weather even the worst of economic storms.”

Making the Fed responsible for the largest firms could work, but only if the Fed throws out pretty much everything about the Greenspan doctrine of cleaning up after financial messes, rather than preventing them. There is no indication they are moving in this direction.

The oversight council is unlikely to make a difference. If you ask someone, “Who is responsible for this problem?” and they answer, “Well, we have a committee,” does that make you feel better or worse?

The administration will not tell anyone the exact capital and liquidity requirements they are proposing, but close observers of the internal administration process have taken to calling the likely increases “dinky”. Remember, the last time our financial system showed this taste for risk and a comparable level of incompetence (prior to 1935), it had equity relative to assets roughly three times current levels (e.g., put into tier one-equivalent terms). There is no proposal on the table, either in the US or within the G20, that is even remotely in the right ballpark. President Obama has put his finger on the problem but is apparently unwilling to do anything about it.

The most remarkable phrasing is probably,

“Even as we’ve proposed safeguards to make the failure of large and interconnected firms less likely, we’ve also proposed creating what’s called “resolution authority” in the event that such a failure happens and poses a threat to the stability of the financial system. This is intended to put an end to the idea that some firms are “too big to fail.””

It is very hard to understand how the administration can say this with a straight face. Certainly a resolution authority would help, but all bank interventions are negotiated receiverships or conservatorships of some kind. When banks are failing, they need a lot of money fast and you have them over a barrel. But if they are vast, complex, and – remember this – cross-border, then taking them over or shutting them down can be scary, whether or not you have a “legal authority”. Please point out to me (a) what the US is pushing the G20 to implement in terms of a cross-border resolution authority, and (b) how you would intervene in a bank like Citigroup (NYSE:C) without a cross-border authority. This rhetoric around this issue is completely not serious – in fact, it’s a distraction from the real issues.

And, of course, the real issues were not mentioned at all.

1. The largest financial institutions have to be made smaller — aim to make them under $100bn in assets, roughly the size of CIT Group (NYSE:CIT) which even this Treasury was willing to leave to its own devices. We can do it with legislation now or by regulatory fiat next time the behemoths get into trouble, but we should do it before they ruin us.
2. The people who run banks like to talk about “skin in the game” in various contexts, but they generally have only a small proportion of their wealth at risk in these financial institutions. This is not a panacea of course, but it is completely fair to ask them to stake a large part of their fortunes. If they respond that this is not fair because all kinds of things can happen that are beyond their control, you should say, “Agreed – so split your bank up and manage something much smaller.”
3. The revolving door between Wall Street and Washington is out of control. There is no way people should be able to go directly (or even overnight) from a failing bank to designing bailout packages to benefit such banks. In any other industry, in any other country, and at any other time in American history, this would have been seen as an unconscionable conflict of interest. Let’s get our principles back and impose a 5 year moratorium on such flows in either direction.
4. The way the Fed operates means that, in the absence of tough regulation, the finance industry has at its disposal the world’s greatest ever bailout machine. Our financial elite knows this and is acting accordingly.

Brandeis was scathing about the individuals behind the financial structures. For him, it was about power and it was about control. He was appalled by how big finance operated and he worked hard – an uphill slog – to rein it in.

But Brandeis never saw anything like what we have now experienced, with regard to the amount of taxpayer money that the banks are able to expropriate when downside risks materialize. The big banks that Brandeis feared did not, in the end, dominate the 20th century. But they are back now, with unfettered power and an arrogance that spells trouble.

Ultimately, we will put the banks back in their regulatory box or they will bankrupt us all.