Ever
since President Barack came to office he has been preoccupied
with efforts to resolve the financial collapse and reverse
the economic downturn that the US has been experiencing
for a year and a half now. But the big economic policy
thrust everyone was awaiting was his administration's
medium- and long-term response to the crisis in the
form of a financial re-regulation package that would
seek to prevent recurrence of crises of this kind. The
consequences of the savings and loans crisis, the dotcom
bust and the financial manipulations at Enron and WorldCom
(among others) were bad enough, but the financial collapse
triggered by the sub-prime crisis was too close to the
1930s to brook further delay in rethinking the deregulation
that is now widely seen as having contributed to these
developments. A Roosevelt moment had come, and it needed
a response that equalled the framework epitomised by
the Glass-Steagall Act of 1933 in significance.
The Obama administration announced the much awaited
package on 17 June led by a statement by the President.
But implicit in that statement were indications of the
compromises that the regulatory package would include-compromises
that could make it inadequate to the task it seeks to
address. While admitting that the economic downturn
was a result of ''an unravelling of major financial institutions
and the lack of adequate regulatory structures to prevent
abuse and excess,'' Obama did not blame the dismantling
of the regulatory regime that was put in place in the
years starting 1933 for these developments. He attributed
them to the fact that ''a regulatory regime basically
crafted in the wake of a 20th century economic crisis-the
Great Depression-was overwhelmed by the speed, scope,
and sophistication of a 21st century global economy.''
Glass-Steagall was not the model for reregulation but
the outdated ‘other' which needed to be substituted
with a new regime. It was not the dismantling of the
structural regulation that Glass-Steagall epitomised
but the vestiges of that framework which remained that
mattered.
Despite this important compromise, there are a number
of important regulatory advances that the new package
incorporates. To start with, recognising that there
are in the current financial scenario a number of institutions-banks
and non-banks-that are too big to fail, because their
failure can have systemic effects, the package gives
a new role for the Federal Reserve in overseeing and
regulating these entities. This implies that institutions
other than banks, which constitute the shadow banking
sector that both mobilised investments and borrowed
many multiples of that to finance its activities, would
come under Fed scrutiny and influence. It is unclear
what the criteria for identifying these ''too big to
fail'' entities would be, but once identified they would
be regulated with the intent of pre-empting fragility.
It hardly bears emphasising that these entities are
not just large in size, but because the walls between
different segments of the financial sector (conventional
banking, investment banking, insurance, etc) were completely
dismantled by 1999, they are diversified as well. To
assist the Fed in monitoring and regulating these diversified
firms, the administration plans to establish a Financial
Services Oversight Council, which would ''bring together
regulators from across markets to coordinate and share
information; to identify gaps in regulation; and to
tackle issues that don't fit neatly in an organizational
chart.'' Moreover these entities would be subject to
more stringent regulations with regard to capital adequacy
and liquidity. Note, however, that the effort here is
not to limit size to prevent the emergence of institutions
that are too big to fail, as has been suggested by some,
but to attempt to prevent failure of large firms.
Since it is impossible to guarantee that this would
work at all times, the package promises to devise a
system that would allow firms to be unwound without
damage to the system and excessive burdens on the tax
payer. The proposed ''resolution authority'' would work
out ''a set of orderly procedures'' for breaking up or
liquidating large and interconnected financial firms
without overly damaging the economy.
A second major lesson from the crisis was that a deregulated
system which allows for securitisation and the transfer
of risk, significantly discounts risk when credit assets
are first originated. This is inevitable since the originator
does not herself carry that risk after transfer. In
addition, experience shows that securitisation aimed
at transferring credit risk and deriving revenues from
fee and commission incomes, also leads to the sequential
creation of composite derivative assets whose complexity
precludes proper assessment of risk. This experience
led to suggestions that such opaque instruments should
be banned, and more transparent, simple and standardised
instruments that are traded in exchanges should be the
norm. This is a suggestion that the Obama administration
has largely sidestepped, though it wants to limit over-the-counter
transactions. According to Treasury Secretary Tim Geithner's
statement to the Senate Banking Committee, the new package
is based on the belief that you cannot ''build a system
based on banning individual products because the risks
will simply emerge in new forms.'' So the focus is on
making instruments more transparent as well as changing
the incentive structure by getting firms to hold a minimum
material interest in the instruments they create. Their
own exposure is expected to limit risk. However, there
is no clear indication who and how riskiness is to be
assessed. Nor is there clarity on whether and how institutions
like the rating agencies, that failed miserably when
assessing risks, would be made to function better.
The result of this liberal approach is that controls
on the kind of ''financial products'' the system can generate
would be restricted to areas where they directly affect
the retail consumer. A new institution-the Consumer
Financial Protection Agency-would have powers to regulate
any institution that provides financial products or
services to retail consumers, whether they be banking
or non-bank entitites. This would, for example, clamp
down on the kind of risky and complex mortgages offered
by mortgage brokers, the implications of which were
not often fully understood by borrowers.
Having decided not to go in for structural regulation,
the new package talks of new guidelines with respect
to capital requirements (''adequacy'') and prudential
norms, which are expected to reduce the degree of leverage
in the system, raise the cost of credit and possibly
affect profitability. According to an administration
official quoted by the Financial Times, the new guidelines
would be aimed at delivering ''more'', ''better'' and ''less
pro-cyclical'' capital.
While these are the core elements included in the new
package, there are many features that were expected
to be dealt with but have been missed out. There are
two in particular that stand out. One is the unwillingness
to substantially reduce the multiple agencies at the
national and state levels, with overlapping jurisdictions,
that currently define the regulatory framework in the
US. Expectations were that the reregulation would deliver
a leaner framework with less agencies that have stronger
and well defined powers and clear cut jurisdictions
of their own. In the effort not to rock the boat by
treading on powerful interests the current reform package
dumps just one agency, the Office of Thrift Supervision,
and balances that with the new consumer protection agency.
Multiple regulators work reasonably well in a world
where segments of the financial system are separated.
That has changed over the last three decades and there
is no intent here to return to the past. In the event,
multiple regulators encourage efforts at regulatory
arbitrage, with institutions seeking the least obtrusive
regulator to register with. It is unclear how the current
reform would deal with this issue.
A second area which the new package leaves untouched
is the much discussed and highly controversial area
of executive compensation in the financial sector. The
issue is not just that some executives were being paid
unjustifiably high salaries and bonuses even in companies
that were not that successful. The real problem was
that the compensation system incentivised risky behaviour
and encouraged speculative investments. In the process
it was not talent or experience that was being rewarded
but the ability to exploit legal loopholes to expand
the business even at the cost of courting excessive
risk. Expectations were that this would be curbed, but
there appears to be no mention of regulation in this
area.
Thus, at the centre of the new financial framework are
a set of unchanged beliefs on how financial markets
function and therefore should be regulated. The first
is that if norms with regard to accounting standards
and disclosure were adhered to, capital provisioning,
in the form of a capital adequacy ratio, is an adequate
means of insuring against financial failure. The second
is that financial innovation should be encouraged. In
the words of Geithner: ''The United States is the world's
most vibrant and flexible economy, in large measure
because our financial markets and our institutions create
a continuous flow of new products, services and capital.
That makes it easier to turn a new idea into the next
big company.'' The third is that this whole system can
be partly secured by allowing the market to generate
instruments that helped, spread, insure or hedge against
risks. These included derivatives of various kinds.
By sticking to these beliefs the Obama administration
has ensured that it does not return to the structural
regulation that Glass-Steagall epitomised, but continues
with the more liberal regime that was fashioned in the
years since the late 1970s. Unfortunately, those were
also the years when bank closures, bankruptcies and
financial crises increased in number, scale and scope.
This is indeed unfortunate because the significance
of the Obama package not only rests in its likely impact
on the world's leading financial firms that operate
out of the US, but in the fact that the US provides
the model for financial systems elsewhere in this globalised
world. If implemented in the US, the Obama administration's
blueprint for 21st Century Financial Regulatory Reform
could serve as the road map for other developed and
developing countries as well. Past experience suggests
that the problem here is not just that President Obama
has not gone far enough. He has left the system vulnerable
to crises of the kind that it is even now battling.
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