The Financial Re-Regulatory Agenda
As the Federal Reserve and Treasury Department careen from one financial meltdown to another, desperately trying to hold together the financial system -- and with it, the U.S. and global economy -- there are few voices denying that Wall Street has suffered from "excesses" over the past several years.
The current crisis is the culmination of a quarter century's deregulation. Even as the Fed and Treasury scramble to contain the damage, there must be a simultaneous effort to reconstruct a regulatory system to prevent future disasters.
There is more urgency to such an effort than immediately apparent. If the Fed and Treasury succeed in controlling the situation and avoiding a collapse of the global financial system, then it is a near certainty that Big Finance -- albeit a financial sector that will look very different than it appeared a year ago -- will rally itself to oppose new regulatory standards. And the longer the lag between the end (or tailing off) of the financial crisis and the imposition of new legislative and regulatory rules, the harder it will be to impose meaningful rules on the financial titans.
The hyper-complexity of the existing financial system makes it hard to get a handle on how to reform the financial sector. (And, by the way, beware of generic calls for "reform" -- for Wall Street itself taken up this banner over the past couple years. For the financial mavens, "reform" still means removing the few regulatory and legal requirements they currently face.)
But the complexity of the system also itself suggests the most important reform efforts: require better disclosure about what's going on, make it harder to engage in complicated transactions, prohibit some financial innovations altogether, and require that financial institutions properly fulfill their core responsibilities of providing credit to individuals and communities.
(For more detailed discussion of these issues -- all in plain, easy-to-understand language, see these comments from Damon Silvers of the AFL-CIO (www.multinationalmonitor.org/mm2007/052007/interview-silvers.html), The American Prospect editor Robert Kuttner, author of the The Squandering of America and Obama's Challenge (www.multinationalmonitor.org/mm2007/112007/interview-kuttner.html), and Richard Bookstaber, author of A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation (www.multinationalmonitor.org/mm2008/072008/bookstaber.html.)
Here are a dozen steps to restrain and redirect Wall Street and Big Finance:
1. Expand the scope of financial regulation. Investment banks and hedge funds have been able to escape the minimal regulatory standards imposed on other financial institutions. Especially with the government safety net -- including access to Federal Reserve funds -- extended beyond the traditional banking sector, this regulatory black hole must be eliminated.
2. Impose much more robust standards for disclosure and transparency. Hedge funds, investment banks and the off-the-books affiliates of traditional banks have engaged in complicated and intertwined transactions, such that no one can track who owes what, to whom. Without this transparency, it is impossible to understand what is going on, and where intervention is necessary before things spin out of control.
3. Prohibit off-the-books transactions. What's the purpose of accounting standards, or banking controls, if you can evade them by simply by creating off-the-books entities?
4. Impose regulatory standards to limit the use of leverage (borrowed money) in investments. High flyers like leveraged investments because they offer the possibility of very high returns. But they also enable extremely risky investments -- since they can vastly exceed an investor's actual assets -- that can threaten not just the investor but, if replicated sufficiently, the entire financial system.
5. Prohibit entire categories of exotic new financial instruments. So-called financial "innovation" has vastly outstripped the ability of regulators or even market participants to track what is going on, let alone control it. Internal company controls routinely fail to take into account the possibility of overall system failure -- i.e., that other firms will suffer the same worst case scenario -- and thus do not recognize the extent of the risks inherent in new instruments.
6. Subject commodities trading to much more extensive regulation. Commodities trading has become progressively deregulated. As speculators have flooded into the commodities markets, the trading markets have become increasingly divorced from the movement of actual commodities, and from their proper role in helping farmers and other commodities producers hedge against future price fluctuations.
7. Tax rules should be changed so as to remove the benefits to corporate reliance on debt. "Payments on corporate debt are tax deductible, whereas payments to equity are not," explains Damon Silvers of the AFL-CIO. "This means that, once you take the tax effect into account, any given company can support much more debt than it can equity." This tax arrangement has fueled the growth of private equity firms that rely on borrowed money to buy corporations. Many are now going bankrupt.
8. Impose a financial transactions tax. A small financial transactions tax would curb the turbulence in the markets, and, generally, slow things down. It would give real-economy businesses more space to operate without worrying about how today's decisions will affect their stock price tomorrow, or the next hour. And it would be a steeply progressive tax that could raise substantial sums for useful public purposes.
9. Impose restraints on executive and top-level compensation. The top pay for financial impresarios is more than obscene. Executive pay and bonus schedules tied to short-term performance played an important role in driving the worst abuses on Wall Street.
10. Revive competition policy. The repeal of the Glass-Steagall Act, separating traditional banks from investment banks, was the culmination of a progressive [sic] deregulation of the banking sector. In the current environment, banks are gobbling up the investment banks. But this arrangement is paving the way for future problems. When the investment banks return to high-risk activity at scale (and over time they will, unless prohibited by regulators), they will directly endanger the banks of which they are a part. Meanwhile, further financial conglomeration worsens the "too big to fail" problem -- with the possible failure of the largest institutions viewed as too dangerous to the financial system to be tolerated -- that Treasury Secretary Hank Paulson cannot now avoid despite his best efforts. In this time of crisis, it may not be obvious how to respect and extend competition principles. But it is a safe bet that concentration and conglomeration will pose new problems in the future.
11. Adopt a financial consumer protection agenda that cracks down on abusive lending practices. Macroeconomic conditions made banks interested in predatory subprime loans, but it was regulatory failures that permitted them to occur. And it's not just mortgage and home equity loans. Credit card and student loan companies have engaged in very similar practices -- pushing unsustainable debt on unreasonable terms, with crushing effect on individuals, and ticking timebomb effects on lenders.
12. Support governmental, nonprofit, and community institutions to provide basic financial services. The effective governmental takeover of Fannie Mae, Freddie Mac and AIG means the U.S. government is going to have a massive, direct stake in the global financial system for some time to come. What needs to be emphasized as a policy measure, though, is a back-to-basics approach. There is a role for the government in helping families get mortgages on reasonable terms, and it should make sure Fannie and Freddie, and other agencies, serve this function. Government student loan services offer a much better deal than private lender alternatives. Credit unions can deliver the basic banking services that people need, but they need back-up institutional support to spread and flourish.
What is needed, in short, is to reverse the financial deregulatory wave of the last quarter century. As Big Finance mutated and escaped from the modest public controls to which it had been subjected, it demanded that the economy serve the financial sector. Now it's time to make sure the equation is reversed.