It
has been more than four years since the onset of the
financial crisis and the accompanying Great Recession
in the US and much of the developed world. Yet, the
crisis is still with us. It has only spread geographically,
with its worst consequences now visible in the peripheral
countries of Europe rather than in the financial centres
of the world where it originated.
Early into the crisis, its severity had resulted in
a near-consensus on the need to re-regulate finance.
The financial and real economy collapse was too close
to the experience of the 1930s to brook further delay
in rethinking the deregulation that is now widely
seen as having contributed to these developments.
There was need for a response that equalled in scope
the Glass-Steagall Act of 1933. How much has been
achieved in the last four years and more? Not much
in Europe, where despite the de Larosière report,
the focus remains on stalling and reversing the ongoing
crisis rather than on preventing future crises. If
financial reform has proceeded anywhere it is in the
US. It began with the Obama Statement of June 2009
on the way forward and culminated in the passage of
the Dodd Frank Act. As a result, efforts are now on
to formulate a set of rules regulating the varied
sets of markets, institutions, activities and instruments
that constitute the complex financial structure that
evolved as a result of financial deregulation. Unfortunately,
the experience till now has been that, while much
was promised, little progress is being achieved.
From the very beginning it became clear that the discussion
on reform in the US was riven by the tension between
those fighting to restrict the response largely to
bailing-out finance and those who were demanding a
return to strong regulation of the pre-1980s kind.
A hint that the actual regulatory package that would
get implemented would include significant compromises
in favour of Finance Capital came early, with the
Obama package. While declaring that the economic downturn
was the result of ''an unravelling of major financial
institutions and the lack of adequate regulatory structures
to prevent abuse and excess,'' the Obama statement
did not blame the dismantling of the regulatory regime
that was put in place in the years starting 1933 for
these developments. It 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.'' The problem was
not that the Glass-Steagall Act was diluted and dismantled,
but that it had lost its relevance.
Implicit in this was the understanding that there
was no question of reversing the dismantling of the
regulatory walls that separated different segments
of the financial sector or of restrictions set on
institutions and agents in individual segments, especially
banking. Other ways, which take account of the changes
in the world of finance, had to be found to rein in
the tendency of the financial sector to proliferate
risk and create conditions for a systemic failure.
Especially because of the externalities involved for
the functioning of the real economy, which required
using taxpayers' money to rescue the system.
Despite this moderation, there were a number of important
regulatory advances that the Obama package, released
as a trial balloon, incorporated. To start with, it
recognised the role played by institutions-banks and
non-banks-that are too big to fail (TBTFs) in the
events leading up to and after the crisis, because
they were systemically important financial institutions
(SIFIs). The top 5 banks, which accounted for just
17 per cent of commercial banking assets in 1970,
held 52 per cent of those assets in 2010 (Chart 1).
Chart
1 >>
(Click to Enlarge)
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. Further, as the Dallas Fed's report notes,
size was built not on equity but on leverage, leading
to a combination of little capital, much debt and
too much risk. Also with size came complexity, and
with complexity came obfuscation. These consequences
of the search for quick and large profits increased
the importance of a few institutions as well as rendered
them prone to failure. But their failure would have
ripple effects across the financial sector and as
a corollary impact adversely on the real economy.
And since for this reason they could not be allowed
to fail, the cost of ensuring their survival had to
be transferred onto the taxpayer. This was what was
done when the crisis occurred, with the state rushing
to the assistance of most large financial firms. As
Charts 2 and 3 show, the assets of institutions that
were assisted to survive during 2008-09 amounted to
$3.22 trillion, where many multiples of the assets
of those that were allowed to fail, which stood at
just $542 million. Much of the financial system was
kept in place with aid from the state.
Chart
2 >>
(Click to Enlarge)
It must be noted that what is at issue here is not
size per se. It is the ''excessive'' size of privately
owned institutions that was the result of speculative
practices aimed at garnering quick profits and permitted
and encouraged by deregulation. Large publicly owned
banks and specialised financial institutions would
not be driven by the same objectives and can exploit
economies of scope to deliver important developmental
benefits.
However, the Dallas Federal Reserve is critical of
size because (i) the need to rescue them left most
Americans with the impression that ''economic policy
favours the big and well-connected'', which is not
good for the policy maker; and (ii) even this massive
transfer of resources has not recapitalised these
institutions adequately and restored normal credit
provision by them. With banks holding back on providing
credit, the Fed's efforts at stimulating a recovery
with a combination of quantitative easing and low
interest rates are not proving very successful. The
irresponsibility of the banks, argues the report,
has undermined the efficacy of monetary policy and
therefore of the Federal Reserve.
Despite this partisan perspective, the Dallas Fed
does underline the fact that little is being done
to address the problem that flows from having privately
managed TBTFs. The Obama package promised a new role
for the Federal Reserve in overseeing and regulating
these entities as well as measures to trim their size.
Discussions on these and other proposals, running
parallel to investigations on the developments that
led up to the crisis in 2007, resulted in the bill
introduced by senators Barney Frank and Chris Dodd,
and finally passed in revised form and signed into
law in July 2010. Since then a number of agencies
such as the Federal Reserve, the Treasury, the Federal
Deposit Insurance Agency and the SEC have been engaged
in a long and slow process of converting the provisions
of the Act into implementable rules and regulations.
The results have thus far been disappointing.
Chart
3 >>
(Click to Enlarge)
The Dodd-Frank Act itself is on occasion disappointing
as in the case of TBTFs. Under the Act these institutions
would be monitored and regulated by a newly established
Financial Stability 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 organisational chart.'' They would also
be subject to more stringent regulations with regard
to capital adequacy and liquidity. However, all this
amounts to an effort to prevent the emergence of institutions
that are considered too important to fail, but to
prevent the failure of large firms without having
to burden the taxpayer. Since it is impossible to
guarantee that this would work at all times, an effort
has been made to devise a system that would allow
firms to be unwound without damage to the system and
excessive burdens on the tax payer.
This, the Dallas Fed, feels is both unconvincing and
unlikely to succeed, and would not serve to restore
faith in ''the system of market capitalism'' based on
competition. It is, therefore, in favour of ''the ultimate
solution for TBTF-breaking up the nation's biggest
banks into smaller units.'' While this position is
controversial, its source and content reflect the
more widespread perception that the opportunity for
reform is being lost. In fact, the too big to fail
issue is not the only one where disappointment is
rife. Another, for example, is the need for some form
of structural regulation that seeks to limit or circumscribe
the activities of the all-too-important banking system.
Under Glass-Steagall this was essentially achieved
by segmenting the financial sector into (i) institutions
that were depository institutions (accepting deposits
from the public at large), which were subject to membership
of the deposit insurance system and were eligible
for liquidity support from the central bank or the
lender of last resort; and (ii) other institutions
including those which accepted investments from high
net worth individuals that were not insured and which
were not eligible for central bank accommodation.
While for a number of reasons a return to this system
was not seen as advisable, the need to limit the activities
of prime depository institutions so as to keep them
out of sensitive sectors involving speculative operations
was recognised by many. Over time those holding this
view gravitated to the ''Volcker rule'' as representing
the minimum acceptable level of separation of activities
between institutions in the financial sector.
The stated objective of the Volcker rule is to ''generally
prohibit any banking entity from engaging in proprietary
trading or from acquiring or retaining an ownership
interest in, sponsoring, or having certain relationships
with a hedge fund or private equity fund (''covered
fund''), subject to certain exemptions.'' Proprietary
trading involved engaging as the principal for any
account used to take positions in securities with
the intention of selling it in the near-term for profit.
Implicit in it was the idea that while separation
of activity could not be complete, since it allowed
banks to serve as agent, broker or custodian for an
unaffiliated third party, banks should not be allowed
to use their own funds, especially those obtained
from depositors, to trade in securities. Besides restricting
banks from engaging in risky activities using depositors'
monies, the proposal was addressing the moral hazard
that arises when bank managers were allowed freedom
in a context where deposits were insured and there
was an implicit guarantee against failure.
This is one area where the Fed, FDIC and SEC have
sat together and attempted to formulate the guidelines
to implement the version of it incorporated in the
Dodd-Frank Bill (DFB). What is striking is the number
of exemptions that have been made with regard to the
proscription on proprietary trading by bank holding
companies (BHCs). The first major set of exemptions
relates to the activities of underwriting or market
making. The rule now permits banks to continue with
the activity of underwriting share issues for clients,
even though that would result in the bank acquiring
equity in instances where under-subscription leads
to shares devolving on the underwriter. Similarly,
by serving as a market maker who stands by with a
bid and an ask price for equities, a bank may find
itself in a situation where it is acquiring stocks
that it cannot find an immediate buyer for, but in
time makes a profit selling it at a significantly
higher price. To distinguish between these activities
and proprietary trading is to draw a fine line, which
can be erased when banks choose to circumvent the
rule. Implementing the rule in practice would, therefore,
prove difficult.
A similar approach is adopted with regard to ''permitted
risk-mitigating hedging activities''. In particular,
by focusing on reining in short-term trading and implicitly
permitting longer-term arbitrage, the rules as framed
may be leaving the door open for the rogue trade.
Finally, the Volcker Rule provides for ''permitted
trading on behalf of customers.'' To that end it identifies
''categories of transactions that, while they may involve
a banking entity acting as principal for certain purposes,
appear to be on behalf of customers within the purpose
and meaning of the statute.'' In sum, the proposed
rules are ambiguous enough to allow banks to circumvent
the law and engage in proprietary trading in some
form.
This too is an example of how, as ideas get translated
into implementable decisions, through the rough-and-tumble
of debate and politics, we are ending up with limited
progress on addressing the failure of regulation that
resulted in the outbreak of the 2007 crisis with its
damaging external effects on the real economy. The
Dallas Fed is also pointing to that danger.
*This
article was originally published in the Business Line
on 2nd April, 2012
