By Clive Crook
Published: June 20 2010 19:06
A US House-Senate conference has started work on merging the chambers’ respective financial reform bills. This tortuous process still has some way to go. The good news is that the plans are similar, and not that different from the blueprint suggested by the administration last year. Agreement will most likely be reached, and the final measure will tick the main boxes. It will be better than nothing. The bad news is that it will be no more than a start.
At a conference last week in New York, 15 distinguished finance and economics scholars presented their own recommendations for financial reform*. The Squam Lake Group, as the economists call themselves, represents a wide range of opinion but is in agreement about most of what should happen. Broadly, the emerging finance bill conforms to the same consensus. Ben Bernanke, chairman of the Federal Reserve, told the meeting: “It appears that final legislation that addresses in some way the great majority of the recommendations ... could be enacted in the next few weeks.”
“In some way”: that is the problem. The fine print will be of paramount importance, but in most cases critical details will be left to the discretion of regulators – or will be settled or shelved in various international forums. At best, the endeavour will stretch on for many months. Ahead of this week’s Group of 20 meeting in Toronto, Dominique Strauss-Kahn, head of the International Monetary Fund, is complaining that the commitment to global co-operation on financial regulation is fading, and has said that the task facing policymakers is still “huge”.
Two key principles stressed by the Squam Lake economists seem universally accepted. One is that financial regulation can no longer concentrate on the soundness of financial groups taken one at a time: the system as a whole also needs to be patrolled, with linkages between institutions and markets taken into account. The second principle is that financial groups – all financial groups – should be made to bear the costs of their failure. This is about efficiency as well as equity. If a bank that gambles can keep its winnings and pass its losses to taxpayers, it will take too many risks.
The Squam Lake economists and the legislative draftsmen agree that a systemic regulator – the Fed – should be given the first job. Defining the second set of tasks is much more complicated. It requires measures to make financial breakdown less likely, and others to ensure that if a bank does fail, its shareholders and creditors, and not taxpayers, suffer the consequences.
Albeit with few specifics, the report and the emerging bill both propose more demanding requirements for capital, liquidity and control of leverage. They call for greater use of standardised instruments and central counterparties, so that risks are smaller, easier to calculate and gathered in plain sight. They provide for new rules on the structure but not the level of financial pay, to discourage excessive risk-taking, chiefly by holding back bonuses. They envisage a new early resolution system for shadow banks, such as hedge funds and specialist vehicles, because ordinary bankruptcy is too disruptive and too likely to put taxpayers on the hook. The report is also keen on contingent convertible bonds – debt that converts to equity under conditions of stress, thus replenishing capital. The bill does not require coco bonds, but could accommodate them.
However, none of this will work without willingness to face down pressure from the industry. Wall Street has conducted a formidable lobbying effort to neuter costly aspects of the bill. How far this has succeeded is debatable. The main planks of reform have survived, so far – but the wide discretion handed to regulators arouses suspicion that the buck is being passed and that the changes in practice will amount to less than they should.
The trouble all along has been that Congress and the regulators are receptive to the argument that stricter regulation will raise the costs of US banks and shadow banks – putting them at a competitive disadvantage. But raising their costs is the whole idea. Risky finance imposes a burden on society. The challenge is to tax banks’ activities in such a way as to bring social and private costs into line.
A capital requirement that rises in proportion to a bank’s size – a policy endorsed by the Squam Lake Group – would tax and discourage balance-sheet growth. This would weigh the taxpayers’ interest in avoiding “too big to fail” – and the subsidy it implies – against economies of scale. Similarly, a capital charge that rises in proportion to a bank’s reliance on short-term borrowing would raise costs in good times in the hope of promoting safety in bad. Most likely, shareholders would suffer from both policies, but that is beside the point: taxpayers would be better off.
Financial regulators supervise an industry where gigantic sums are at stake and workers are clever and mobile. If banks lobby regulators for competitive advantage and fail, they can move to milder jurisdictions.
The only remedy is international harmonisation, or at any rate close co-operation. But this looks problematic. Big differences in philosophy are evident. Much of Europe prefers a heavier-handed approach. Germany, for example, recently moved to ban naked short selling – the selling of securities you do not possess. In the end, if the US and Europe cannot act in concert, the work that Congress has done on financial reform may be for naught.
*The Squam Lake Report: Fixing the Financial System, Princeton University Press
Copyright The Financial Times Limited 2010.
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