SERIOUS MONEY:Barack Obama's plans for financial regulation do little to stop banks becoming too big to fail, write CHARLIE FELL.
WILLIAM SHAKESPEARE'S Much Ado about Nothing madeits first appearance during the winter of 1599. In Act II scene I, the orphan Beatrice tells the disguised Benedick that "he is the prince's jester, a very dull fool".
More than four centuries later and to great fanfare, Team Obama released its 85-page white paper entitled Financial Regulatory Reform: A New Foundationlast week. Its contents though reveal that its authors are nothing more than court jesters dancing to the tunes played by the princes on Wall Street. Investors are fools if they think that this set of proposals will prevent a repeat of the current financial crisis in the years ahead.
Team Obama has portrayed the current crisis as having arisen from an inadequate regulatory apparatus as opposed to the harsh reality where a combination of regulatory capture and negligence saw regulators simply fail to regulate. No one is being held accountable even though regulators, most notably the Federal Reserve, certainly did have the tools available to moderate excessive risk-taking before irrational exuberance took hold, but they chose instead not to act.
It is beyond dispute that financial innovation and the resulting alphabet soup of structured finance products made the financial system less transparent and more interconnected than ever before, but there is still no escaping the fact that the Federal Reserve, under the stewardship of Alan Greenspan, kept interest rates far too low for far too long and in so doing, precipitated a bubble in the housing market.
The Greenspan Fed applauded the growth in subprime and Alt-A adjustable rate mortgages, argued that the diversification of risk across more-and-more investors as a result of financial innovation had contributed to greater financial system stability. When it finally tightened monetary policy, it did so in “baby steps”, such that the risks posed by the entrenched euphoria continued to grow.
The Federal Reserve possessed the tools to act but chose not to. It was not alone as most regulatory agencies followed the same path.
The failure to apportion blame to the regulators is troubling because it provides no incentive for regulators to perform their assigned tasks effectively.
If regulators bear no responsibility for their failures, then regulatory capture where officials inappropriately identify with Wall Street interests is far more likely such that even a perfect regulatory structure is unlikely to work.
The Obama plan, however, is far from perfect and does little if anything to prevent banks from becoming too big to fail. The proposals in their current form would authorise the Federal Reserve to establish a special regulatory regime including capital, leverage and liquidity requirements for any firm where the “combination of size, leverage, and interconnectedness could pose a threat to financial stability if it failed”.
These firms would be required to hold more capital than smaller financial institutions but the implicit guarantee arising from their “too-big-to-fail” status would reduce the perceived risk of lending to them and thus, enable them to obtain funds at a lower cost than their smaller brethren.
Furthermore, although the white paper identifies compensation practices as a major cause of the crisis, it does nothing to address the skewed incentives that resulted in an excessive focus on short-term profitability.
If the practice continues whereby senior executives earn substantial bonuses on short-term profits but can expect nothing short of a golden parachute if excessive risk-taking leads to large losses, then those firms that are designated as too big to fail have every incentive to gamble in order to boost profitability in the face of higher capital requirements.
The proposals would require that the originator of a securitisation retain a financial interest in its performance. However, the “skin in the game” provision at just 5 per cent is far too low to ensure that financial institutions lend responsibly and this is likely to be particularly so in a rampant bull market where senior executives have strong financial incentives to book short-term profits.
Indeed, although the Federal Reserve lauded the diversification of risk across investors as a result of the seemingly endless flow of innovations in structured finance, such diversification never actually took place as banks and other financial institutions maintained significant exposure to real estate related assets, which increased as a share of total assets in recent years.
Real-estate related assets reached almost one half of total assets at major banks and roughly two-thirds of assets at smaller banks yet such high levels of “skin in the game” did not prevent reckless and irresponsible lending.
The proposals do have some merit, including much-needed regulation of the “shadow” banking system, but the white paper as a whole falls well short of that required to prevent the re-emergence of the type of excesses that almost broke the financial system during the most recent crisis episode.
The major banks are already attempting to return to business as usual such that the proposed financial system reform, just like the not-so-demanding stress tests a month ago, should be considered as “much ado about nothing”.
