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By Nicole Gelinas

After The Fall: Saving Capitalism From Wall Street--and Washington

Eye on the News

Nicole Gelinas
A Better, Simpler Financial Fix
Markets don’t need more regulatory discretion; they need clear limits on risk-taking.
19 June 2009

While President Obama and the Democratic Congress prepare to overhaul U.S. financial regulations, Republicans have struggled to find a voice in the debate. They might start by making the case for this: giving financial firms the freedom to thrive within well-defined limits on risk-taking, and subjecting the companies to market discipline. Without clearly setting such limits and without imposing such discipline, the plan that the White House released Wednesday instead threatens a stealth return to the status quo.

The White House is pushing for the creation of a “financial services oversight council,” which the Treasury Department would head and other regulatory agencies advise. Obama proposes further that the Federal Reserve supervise “all firms that could pose a threat to financial stability,” including those (like big insurance companies) that aren’t banks. Proponents say that the council and the new directive to the Fed to look out for financial stability are necessary. Though many regulators have authority over certain types of financial companies and markets, supporters say, no one has the job of monitoring the entire financial system for “systemic risk.” This risk is that firms’ and markets’ behavior could threaten the financial world’s ability to function and hurt the broader economy, as in the cases of investment banks Bear, Stearns and Lehman Brothers and insurer AIG.

But a “systemic-risk” regulator would not have prevented the financial meltdown. In fact for decades, the Federal Reserve has been a systemic-risk regulator in all but name. From the eighties until the first half of this decade, the Fed had ample discretion over most financial firms and markets, and its clout with Congress and with the public was such that if it found an area where its power fell short, it easily could have won the statutory authority to act. Moreover, the Fed enjoyed plenty of independent feedback from other regulatory institutions, and from within its own ranks. The problem wasn’t a lack of power but an irreducibly human flaw: sometimes the Fed used its power properly, and sometimes it didn’t.

Two events, more than a decade apart, illustrate this point. In 1985, then-Fed chairman Paul Volcker saw a new risk to the system: through junk-bond markets, “corporate raiders” could borrow liberally and use the money to launch corporate takeovers. This innovation usefully introduced new market pressures to sometimes sclerotic management teams and boards of directors. But without necessary regulatory checks, junk bonds eventually became a self-perpetuating speculative mania. As investors reaped huge profits from easy takeovers, junk-bond buyers saw less risk, so they financed deals even more readily. Easy money pushed stock values up (as well as bond values), not because the stocks were more valuable, but because everyone hoped to benefit from the next takeover of a publicly traded company. So Volcker reined in what he saw as excessive speculation by using the Fed’s ample discretion to apply existing principles to a new market. The Fed imposed Depression-era margin requirements—which restrict borrowing for securities purchases—on the corporate-takeover market.

More than a decade later, the Fed used its still-broad authority differenty. In 1998, the then-commissioner of the Commodity Futures Trading Commission, Brooksley Born, saw an acute threat to the system in unregulated derivatives—including what would grow to become the “credit-default-swap” market. Born warned fellow regulators, and Congress, that these derivatives posed “unknown risks to the U.S. economy and to financial stability around the world” because of their “lack of transparency” as well as “unlimited borrowing . . . like the unlimited borrowing on securities that contributed to the Great Depression.” She fought fiercely for jurisdiction to apply Depression-era borrowing limits to the new markets. This time, the Fed used its credibility, clout, and discretion to counsel against such power. Congress bowed to its judgment in 2000.

The two episodes show that though regulators must enjoy some discretionary powers, it’s what they do with that discretion that matters. They must have the common sense to recognize when new markets need clear limits—including borrowing limits and risk-disclosure requirements—to reduce threats to the broader economy. Creating a systemic-risk regulator, in fact, would represent a continuation of the modern regulatory confusion that helped precipitate the financial crisis. From early derivatives and mortgage-securities blow-ups in 1994 to the collapse and rescue of the Long-Term Capital Management hedge fund in 1998, Washington consistently confused what kind of financial risk-taking warranted placing objective limits on borrowing and other behavior, and what kind required only regulators’ attention, surveillance, and occasional speeches exhorting market participants, well, to be careful.

Clear, non-discretionary limits are necessary in financial markets, precisely because sometimes, nobody sees any risk at all—and then, all the power in the world won’t help. Instead of focusing on a systemic-risk regulator, then, Congress should work with existing regulators to reinforce principles that limit risk-taking. Many of these principles date back to the Great Depression, but they have badly eroded over the past two decades.

Most important, no financial institution or financial instrument should escape clear, non-negotiable controls on borrowing and lending. Overconfident borrowing and lending based on subjective risk measures precipitated the credit crisis and deep recession. Over the decade or so leading up to 2007, financial institutions, right under regulators’ noses, borrowed so heavily against their supposedly “safe” securities that they had no room for error when those securities fell in value.

Those controls should not depend on a subjective risk assessment like a security’s triple-A rating, just as government limits on borrowing in the stock market aren’t held hostage to such subjectivity. It’s dangerous when everyone is thinking the same thing in a bubble. Nor should the controls allow for micromanagement. Once regulators decide that companies can borrow only a certain level against their capital and against their financial instruments, the firms largely should be free to take creative risks within those limits. Further, no significant financial market should get away with what the unregulated derivatives market did for so long—escape the discipline that comes from trading on an exchange or clearinghouse.

The Obama administration has taken some positive steps here, with Treasury Secretary Tim Geithner’s reasonable, if imperfect, proposal to set borrowing limits on currently unregulated derivatives. The plan also urges regulators to “reduce their use of credit ratings in regulations and supervisory practices, wherever possible.”

But the White House has delayed taking action on the most obvious way to limit borrowing—new, consistent capital requirements for financial firms and all their investments—directing the Treasury to issue a report by the end of the year. The creation of a systemic-risk regulator in the absence of clear boundaries on risk-taking at financial firms could encourage yet more hubris and complacency in financial markets. A regulatory council that the government thinks smart enough to manage any and all risk might encourage market participants and their lenders to continue to act recklessly, confident that someone is looking out for them.

Complacency is likely for another reason: the Obama administration has made clear that the government does not want to get rid of the “too big to fail” policy for big or complex financial firms. Instead, the White House would formalize “too big to fail” by giving Treasury new power to “provide for the ability to stabilize a failing institution . . . by providing loans to the firm, purchasing assets from the firm, guaranteeing the liabilities of the firm, or making equity investments in the firm.” In such cases, the White House would not direct Treasury to make sure that bondholders and other creditors take losses in a consistent manner—a key ingredient to instituting market discipline over financial firms and instruments. Nor would it direct Treasury to sell off the assets of failed firms to the private sector as soon as practically possible.

The “too big to fail” doctrine, which has governed the financial markets for a quarter of a century, undermined market discipline and led to the current disaster. So long as the administration sticks with this approach, any other reasonable regulations it imposes won’t matter. The abject lack of market discipline fostered by “too big to fail” will guarantee that big financial firms continue to have the cheap money and the motive—unlimited upside for shareholders and employees and no downside for the lenders that provide the money—to find their way around regulations, good, bad, or indifferent.

Nicole Gelinas, a contributing editor to City Journal, is the author of the forthcoming After the Fall: Saving Capitalism from Wall Street—and Washington.

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