Proposal to Expand Powers of the FED

[magerette]

The U.S. Secretary of the Treasury, Henry Paulsen, is unveiling a new plan to deal with financial turbulence and outmoded regulation within the banking industry in the face of the subprime bust --to me it looks like at best a classic case of locking the barn door after the horse has been stolen, and at worst like an insidious plot to beat the Dems to tougher proposals, but I admit to being an economics lightweight.

Anybody else have any ideas on how this may pan out?

Here's a few bits from the story as it broke tonight in the New York Times (http://www.nytimes.com/2008/03/29/business/29regulate.html?_r=1&hp&oref=slogin):
The Treasury Department will propose on Monday that Congress give the Federal Reserve broad new authority to oversee financial market stability, in effect allowing it to send SWAT teams into any corner of the industry or any institution that might pose a risk to the overall system...
According to a summary provided by the administration, the plan would consolidate an alphabet soup of banking and securities regulators into a powerful trio of overseers responsible for everything from banks and brokerage firms to hedge funds and private equity firms.

While the plan could expose Wall Street investment banks and hedge funds to greater scrutiny, it carefully avoids a call for tighter regulation.

The plan would not rein in practices that have been linked to the housing and mortgage crisis, like packaging risky subprime mortgages into securities carrying the highest ratings.

The plan would give the Fed some authority over Wall Street firms, but only when an investment bank’s practices threatened the entire financial system.

And the plan does not recommend tighter rules over the vast and largely unregulated markets for risk sharing and hedging, like credit default swaps, which are supposed to insure lenders against loss but became a speculative instrument themselves and gave many institutions a false sense of security.

...Parts of the plan could reduce the power of the Securities and Exchange Commission, which is charged with maintaining orderly stock and bond markets and protecting investors. The plan would merge the S.E.C. with the Commodity Futures Trading Commission, which regulates exchange-traded futures for oil, grains, currencies and the like.

The blueprint also suggests several areas where the S.E.C. should take a lighter approach to its oversight. Among them are allowing stock exchanges greater leeway to regulate themselves and streamlining the approval of new products, even allowing automatic approval of securities products that are being traded in foreign markets....

But Mr. Paulson’s proposal would fall well short of the kind of regulation that Democrats have been proposing. Mr. Frank and other senior Democrats have argued that investment banks and other lightly regulated institutions now compete with commercial banks and should be subject to similar regulation, including examiners who regularly pore over their books and quietly demand changes in their practices.

[V7]

Looks a little like the rationalisation the UK did a few years back although they never had the absurd seperation between investment and commercial banking. You're also right about backwards looking nature but most financial reforms tend to follow that pattern, a bit like the generals planning to fight the last war.

[Prime Junta]

That looks to me more like window dressing than a serious attempt to address the problems. Some states attempted to put tighter regulations on subprime loans a while back, but the Bush government vetoed them, saying that it was the Fed's job -- but it did not give the Fed the budget and resources to actually *do* the oversight. (Not that Greenspan was very keen to do it anyway, Objectivist/Libertarian that he is... or, rather, was; he seems to have come around a big way since he retired.)

In other words, the issue wasn't so much the Fed's lack of regulatory power as a lack of resources and willingness to exercise that power.

Moreover, the main problem is that during the past thirty-odd years, Wall Street had come up with ingenious ways to get around the financial sector regulations. The banking system's regulatory structure is based on a "quid pro quo" between the banks and the government -- the government promises to bail out a failing bank so that there won't be any bank runs, and the bank agrees to subject itself to regulation that limits the kinds of risks it's allowed to take.

The way Wall Street got around this "problem" was by creating a "shadow banking system" -- financial institutions that weren't technically banks, and therefore weren't subject to regulations, but that did what banks traditionally do anyway. Now that the shit has hit the fan, the government has pretty much no choice but to bail them out (the alternative being a "domino effect" meltdown of the entire financial sector, which would certainly cost the economy, the taxpayer, and the government an order of magnitude more than a mere half-trillion bailout). IOW, we're in the classic situation that regulation was supposed to prevent -- the profits from the good times were privatized but now the risk is socialized.

V7: what's absurd about the split between commercial and investment banking? IMO it's the single most sensible financial sector reform that came out of the Great Depression.

[Corwin]

Pardon my ignorance on this matter, but what is the difference between commercial and investment banking? To my knowledge, we don't use those terms here!!

[Prime Junta]

Investment banks deal in securities, stock markets, commodity markets, derivatives such as futures, options, obligations, and so on. Commercial banks do what banks are traditionally expected to do -- accept deposits and issue loans (to private individuals and companies).

The reason the two were split in the US after the Great Depression is that the financial sector is the connection between the real economy and the securities markets. If the same banks do both investment and commercial banking, and the markets crash, the crash will wipe out any money deposited in them through commercial banking, and will also destroy their ability to issue credit to people and companies. In other words, the crash in the securities market will also wipe out a big chunk of the real economy, as people and companies see their savings disappear and their credit lines close.

Conversely, if they're split, the investment banks will be wiped out (or suffer heavy losses) in the market crash, but the commercial banks will continue to operate normally, and the real economy will be much less severely affected.

[Corwin]

Thanks for the info. I'm not really sure how the system works here. I think our banks do both, but there could be some regs governing the operation. Dhruin might have more idea since he lives in the business capital of the country!!

[V7]

America is the only country I know that enforces a split between investmenet and commercial banking. In Australia Maquarie is more investment than commercial bank and Westpac or Commonwealth more commercial than investment. Investment bankers are the guys who do the IPOs, M&As, debt issues and so on, while the commercial bankers manage your savings account and approve your mortgage. America's current trouble is in part because the investment guys figured out they could package a portfolio of not-too-good house loans the commercial guys made and sell it to investors.

PJ: been putting off responding re the banking separation, not really up to a long discussion of banking regulation at the moment - in short the banks waste a lot of time and talent getting round it and all the other financial centers manage fine without it. Its also arguably left the US banking system even more fragmented and prone to regional crises than it already was.

[Prime Junta]

Actually, ever since Gramm-Leach-Bliley, not even the US enforces this split. And, strangely enough, eight years later, the US financial sector is undergoing its worst crisis since the 1930's -- and uncannily similar to the crisis that led to the split in the first place. And as you point out, the root cause is directly related to the recoupling between the two.

Once again: this is all based on the bargain between the state and the banks that prevents bank runs -- the state insures deposits, and simultaneously requires that banks don't take too big risks with the money deposited in them. Without this state insurance, banks would be risking runs on them, due to rumors or, of course, genuine problems. Without the safeguards, the insurance would simply privatize the profits and socialize the risks, which would lead to a huge moral hazard -- not to mean that it'd be hugely unfair. Splitting investment and commercial banking isn't the *only* way to stop banks from taking too big risks with their depositors' money, but in the absence of other such safeguards, the split worked -- and getting rid of it had a direct causal connection to the current crisis.

[V7]

I'd have to disagree with you there, the root cause was a lack of due dilligance first by the commercial banks and then by the investment banks and investors. They underestimated the risks, thats nothing to do with the structure of the banks. The regulators should probably have been keeping a closer eye on their risk profiles too. IN that sense its not disimiliar to what happened with the Texas savings and loan crisis, bad loans are trouble wherever they are in the system.

[magerette]

The part that I dislike is where they mess with the SEC, but it's unclear in the article just how it's designed to work. Merging the SEC into the Commodities regulating body is one of those things that sounds good on paper but is difficult to implement--and makes little real sense--one oversight agency seems inadequate, and judging by how well existing agencies cooperate with each other, I don't see that as a very productive path to stroll down. If anything, I would think reinforcing the autonomy of the SEC would be a better idea.

[Prime Junta]

I'd have to disagree with you there, the root cause was a lack of due dilligance first by the commercial banks and then by the investment banks and investors. They underestimated the risks, thats nothing to do with the structure of the banks. The regulators should probably have been keeping a closer eye on their risk profiles too. IN that sense its not disimiliar to what happened with the Texas savings and loan crisis, bad loans are trouble wherever they are in the system.

That's correct -- a sound regulatory structure with good oversight will work too. However, if financial and commercial banking are integrated, that means both sides need to be "policed" (i.e., regulated and audited) equally well. Since the financial side is an order of magnitude more complex than the commercial side, and evolving all the time too, this means a lot tighter and a lot more complex regulation. In today's global marketplace, these are obviously competitive disadvantages.

Most countries have taken this route anyway, and when done well, it works fine. There's always a cost, though: the cost of doing investment banking goes up, since regulations can't be enforced for free, and the sector becomes less open to innovation, since many quite legitimate innovations would not be compatible with the regulations.

The unique situation of the USA is that when Gramm-Leach-Bliley repealed Glass-Steagall, no significant new regulation was introduced to mitigate the risks the repeal caused. In fact, at the time the bill was passed, the political climate was so anti-regulatory that it would have been impossible to pass any such regulation.

Again: the point of the split isn't to reduce the risks banks can take in their business; it's to firewall the risky and volatile part of the business off from the stable, low-return one, in order to prevent contagion of a financial crisis from the one to the other -- precisely the kind of coupling that the mortgage-backed securities and other innovative securities caused now.

[V7]

I'm not sure that the regulations are that much of a competitive disadvantage, the investment banks are still regulated in the US, and, while they're successful they're not clearly ahead of the foreign banks - operations in foreign markets are are regulated by the locals anyway. As for innovation I don't think they're clearly ahead there either, anecdotally I'd put them ahead of the Japanese but behind London and Singapore. I could be wrong but the advantage doesn’t look clear to me at all... and then there's the commercial side, anyone who's had dealings with commercial banks in the US can tell you they're expensive and inefficient, its been getting better as the banking system has consolidated but they're miles behind every other banking system I've had experience with in service, value, products and efficiency (except perhaps the French).

[blatantninja]

I haven't had time to really parse through the proposal, but I will be as it affects my livelihood directly. As tot he comment about closing the barn door too late, I think that's a bit in accurate. Obviously, this is a reactionary proposal, however it's important that a reaction be done to keep it from happening in the future.

Now that said, after Sarbox, I have little faith that the federal government will keep from over regulating.

[Prime Junta]

From my quick look through it, there really doesn't seem to be much of substance in it -- no new regulation or regulatory agencies, just shuffling around the boxes on the org chart. IOW, a whole lot of work for the bureaucrats in rearranging the administrative processes, but nothing done to actually address the causes of the crisis.

[dteowner]

And then you chastise me for painting myself in an ideological corner.

"IOW, a whole lot of work for the bureaucrats in rearranging the administrative processes, but nothing done to actually address the causes of the crisis."

Welcome to another episode of Government, American Style. It's no surprise I've thrown in the towel--even a commie fer-ner can see it's broken beyond repair. ;)

[Prime Junta]

I can see it's broken, but I don't see that it's broken beyond repair.

[Alrik Fassbauer]

I see it just needs quite some efforts to get it repair'd again.

[mudsling3]

http://www.npr.org/templates/story/story.php?storyId=89338743&sc=emaf

This guy put the problem in terms I can understand. more dumbass agences and regulations??? NO! I disagree with his solution for obvious reason, just get rid off the Fed, everyone would tread much more cautiously.

[Prime Junta]

Yay, more Austrian Kool-Aid.

[zahratustra]

NO! I disagree with his solution for obvious reason, just get rid off the Fed, everyone would tread much more cautiously.

Mind boggles....:mwahaha: