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Financial Regulation: A Little Common Sense, Please


Welcome back, growth. For the first time since governments massively intervened to prevent a global collapse in September 2008, it appears that an economic recovery is taking hold. Yet even as the U.S. economy emerges from its worst recession since the 1930s, the fundamental underlying economic and regulatory problems that precipitated the crisis remain mostly unaddressed. Most important, while there are plenty of proposals for overhauling financial regulation floating around—from legislators, think tanks, and academia—little has been accomplished so far. That's a shame. Without major reform, financiers will once again drive the economy toward the brink of destruction. After all, the lesson of the past three decades is that the government safety net has been widely extended. It won't happen tomorrow or even next year but when the good times roll again—and they will—memories will fade and profligacy will drive out prudence. Financiers will take bigger risks by borrowing way too much to speculate and gamble, well aware that the profits remain privatized while the losses have been socialized. It's a recipe for disaster, and there's no guarantee that governments will cobble together a successful rescue plan the next time the boom goes bust. Glass-Steagall ReconsideredWhere to start, then? Tinkering with the existing system may be politically expedient, but it's a big mistake. Washington should pay attention to the more radical reform proposals. One of the most popular ideas has found favor with such diverse figures as former Federal Reserve Board Chairman Paul Volcker and Senator John McCain (R-Ariz.). Simply put: Separate finance into two basic units, a very safe, narrowly circumscribed banking sector and risk-taking institutions that play in the capital-market casino. It's one way to limit the risk that some banks are "too big to fail" and reduce the odds of another government bailout of the banking system. Sound familiar? It should. A famous version of this idea is the landmark Glass-Steagall Act of 1933. It prevented bank holding companies from underwriting securities and owning other financial companies, such as insurers. Indeed, the whole financial system was largely compartmentalized in the decades following that traumatic decade, with competition extremely restricted between commercial banks, thrifts, insurance companies, and investment banks. However, the Depression-era law was repeatedly weakened over subsequent decades and it was eventually repealed in 1999. A number of prominent senators and representatives are considering bringing it back. Bringing back Glass-Steagall is an idea well worth considering. Problem is, it may take regulatory reform in the wrong direction. Put it this way: The mistake wasn't in repealing Glass-Steagall. It was in leaving the job half-finished so that what remained was a bonus-obsessed, undercapitalized, underdisciplined, and politically savvy financial system. After all, Bear Stearns and Lehman Brothers were charter members of the casino. Yet it's their demise that almost cratered the global economy. On the flip side, Bank of America (BAC) buying Merrill Lynch actually helped shore up the system. It's hard to imagine that financiers wouldn't eventually devise ways to recreate another shadow banking system for getting around regulatory barriers. It's in the nature of the beast. "The more drastic the regulation and the more it hurts profits, the greater the tendency to weaken the regulations in times of growth," says Raghuram G. Rajan, finance professor at the University of Chicago's Booth School of Business and formerly chief economist at the International Monetary Fund. The economy and taxpayers are at risk to many kinds of leveraged firms whether it's called an investment bank, insurance company, commercial bank, or hedge fund. The key is to end up with a modernized, streamlined regulatory structure that reflects the reality of competition and overlap among financial-services companies. Rules for Leveraged FirmsA regulatory regime that essentially treats leveraged financial services the same is based on the insight that the forces that brought us to this sorry state of affairs are powerful. That point was brought home in rereading a remarkable speech given in 1985 by Albert M. Wojnilower, then the well-known chief economist at First Boston. In Financial Change in the United States, Wojnilower reviewed the dramatic transformation of the U.S. financial system over the previous two decades. He clearly saw how competition was destroying compartments, propelled in large part by zeal among financiers to evade regulations, the march of information and communications technologies, the erosion of national and international barriers, and the dependence of the financial system on government bailouts. He didn't like it. The trend worried him. Yet the elements he identified strengthened over the subsequent two decades, giving free rein to "the ingrained human propensities to borrow, lend, speculate, and gamble." Leveraged financial firms should be required to carry higher capital ratios. The requirements surrounding greater transparency are good, too. But there are a number of intriguing ideas that essentially rely on creating automatic market-based mechanisms that reinforce regulatory discipline, punish wrongdoers, and limit the odds of a government handout. For instance, Rajan proposes that highly leveraged financial firms be required to issue debt with covenants that automatically convert the bondholders into equity owners in times of trouble. The trigger for the ownership swap could be regulators saying the system is in crisis or the firm's finances breach certain safe ratios of capital and assets. The requirement would include everyone from Goldman Sachs (GS) to Citigroup (C) to John Hancock. The covenant could certainly make existing owners wary of making too-risky bets. It certainly would help keep losses painfully private. That market-based system could be strengthened by additional measures. For example, highly geared financial institutions also could be required to sell capital insurance bonds to sovereign wealth funds, private equity firms, and other deep-pocket investors. The proceeds would be invested in default-free Treasury bonds and placed in a custodial account, say, at State Street Bank (STT). The risky firms in question would pay the bond buyer an insurance premium and the buyer would pocket the interest payments on the Treasury securities. Yet under certain dire circumstances the money in the fund would be released to shore up the finances of the troubled firm. A combination of uniform government regulation reinforced by market mechanisms could bring moderation to all things in finance. After all, no one wants to eliminate booms. "In any case, the animal spirits of enterprise, risk-taking, and innovation will always breed booms rather than sleepy and stable environments," wrote the late Peter Bernstein, the dean of finance economists. But booms mean there will be busts. A lighter but more standardized regulatory system that allows financiers to take moderate risks, no matter what their business, but quickly and automatically punishes excessive gambling could be the way to go.
Chris_farrell
Farrell is contributing economics editor for Bloomberg Businessweek. You can also hear him on American Public Media's nationally syndicated finance program, Marketplace Money, as well as on public radio's business program Marketplace.

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