Obama’s Regulatory Brain

The most important thing to know about the 1,500 page financial reform bill passed by the Senate last week — now on he way to being reconciled with the House bill — is that it’s regulatory. If does nothing to change the structure of Wall Street.

The bill omits two critical ideas for changing the structure of Wall Street’s biggest banks so they won’t cause more trouble in the future, and leaves a third idea in limbo. The White House doesn’t support any of them.

First, although the Senate bill seeks to avoid the “too big to fail” problem by pushing failing banks into an “orderly” bankruptcy-type process, this regulatory approach isn’t enough. The Senate roundly rejected an amendment that would have broken up the biggest banks by imposing caps on the deposits they could hold and their capital assets.

You do not have to be an algorithm-wielding Wall Street whizz-kid to understand that the best way to prevent a bank from becoming too big to fail is preventing it from becoming too big in the first place. The size of Wall Street’s five giants already equals a large percentage of America’s gross domestic product.

That makes them too big to fail almost by definition, because if one or two get into trouble – as they did in 2008 – their demise would shake the foundations of the financial system, even if there were an “orderly” way to liquidate them. Because traders and investors know they are too big to fail, these banks have a huge competitive advantage over smaller banks.

Another crucial provision left out of the Senate bill would be to change the structure of banking by resurrecting the Depression-era Glass-Steagall Act and force banks to separate commercial banking (the classic function of connecting lenders to borrowers) from investment banking.

Here, too, the bill takes a regulatory approach instead. It includes a provision barring banks from “proprietary trading,” or making market bets with their own capital. Even if this regulation were tough enough (and the current Senate bill requires various delays and studies before it’s applied), it would not erode the giant banks’ monopoly over derivatives trading, adding to their power and inevitable “too big to fail” status.

Which brings us to the third structural idea, advanced by Senator Blanche Lincoln. She would force the banks to do their derivative trades in entities separate from their commercial banking.

This measure is still in the bill, but is on life-support after Paul Volcker, Tim Geithner, Fed chair Ben Bernanke, and Larry Summers came out against it. Republicans hate it. The biggest banks detest it. Virtually every major Wall Street and business lobbyist has its guns trained on it. Almost no one in Washington believes it will survive the upcoming conference committee.

But it’s critical. For years the big banks have relied on taxpayer-funded deposit insurance to backstop their lucrative derivative businesses. Obviously they want the subsidy to continue. Bernanke argues that “depository institutions use derivatives to help mitigate the risks of their normal banking activities.” True, but irrelevant. Lincoln’s measure would allow banks to continue to use derivatives. They just could not rely on their government-insured deposits for the capital.

Requiring banks to do derivative trading in separate entities would force them to raise extra capital. But if such trading is so useful, banks should foot the bill, not taxpayers. Bernanke and others say the measure would give foreign banks a competitive advantage. Even if he is right, since when is it up to taxpayers to guarantee profitability at America’s largest banks relative to foreign ones?

The trading of derivatives is not so crucial to the US economy that taxpayers should subsidise the practice. If the past two years have taught us anything, the lesson is just the opposite. Derivatives can generate huge risks unless carefully regulated.

Wall Street’s lobbyists have fought tooth and nail against these three ideas because all would change the structure of America’s biggest banks. The lobbyists won on the first two, and the Street has signalled its willingness to accept the Dodd bill, without Lincoln’s measure.

The interesting question is why the president, who says he wants to get “tough” on banks, has also turned his back on changing the structure of American banks — opting for a regulatory approach instead.

It’s almost exactly like health care reform. Ideas for changing the structure of the health-care industry — a single payer, Medicare for all, even a so-called “public option” — were all jettisoned by the White House in favor of a complex set of regulations that left the old system of private for-profit health insurers in place. The final health care act doesn’t even remove the exemption of private insurers from the nation’s antitrust laws.

Regulations don’t work if the underlying structure of an industry — be it banking or health care — got us into trouble in the first place. Wall Street’s big banks are just too big, and their ability to draw on commercial deposits for investment banking activities, including derivatives, will make them even bigger. It will also subject the economy to greater and greater risks in the future. No amount of regulation can cure that.

Similarly, the underlying system of private for-profit health insurance is a key driver of America’s bloated and ineffective health care delivery. We can try to regulate it like mad, but no amount of regulation will cure this fundamental problem.

A regulatory rather than structural approach to deep-seated problems in complex industries like banking and health care is also vulnerable to the inevitable erosion that occurs when industry lobbyists insert themselves into the regulatory process. Tiny loopholes get larger. Delays get longer. Legislative words are warped and distorted to mean what industry wants them to mean.

Both Senate and House financial reform bills exempt “customised” derivatives from the exchanges, for example, but leave it to regulators to define what contracts will be excused. Yet many of the derivatives that caused the most trouble (read Goldman Sachs and other banks’ deals with AIG) might well be thought of as customised. Another potential problem: in assigning consumer protection to the Fed, the bill puts it under Fed chiefs who in the past disdisplayed a patent disregard of such safeguards (read Alan Greenspan).

Inevitably, top regulators move into the industry they’re putatively trying to regulate, while top guns in the industry move temporarily into regulatory positions. This revolving door of regulation also serves over time to erode all serious attempt at overseeing an industry.

The only way to have a lasting effect on industries as large and intransigent as banking and health care is to alter their structure. That was the approach taken to finance by Franklin D. Roosevelt in the 1930s, and by Lyndon Johnson to health care (Medicare) in the 1960s.

So why has Obama consistently chosen regulation over restructuring? Because restructuring Wall Street or health care would surely elicit firestorms from these industries. Both are politically powerful, and Obama did not want to take them on directly.

A regulatory approach allows for more bargaining, not only in the legislative process but also, over time, in the rule-making process as legislation is put into effect. It’s always possible to placate an industry with a carefully-chosen loophole or vague legislative language that will allow the industry to continue to go on much as before.

And that’s precisely the problem.

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