Bernanke on Regulation

Highlights include American International Group, Inc. (AIG), Citigroup, Inc. (C), JPMorgan Chase & Co. (JPM), Wells Fargo & Co. (WFC) and Bank of America Corp. (BAC).

This morning, Fed Chairman Ben Bernanke gave a speech on the topic of financial regulation and the lessons learned from the recent disaster. Here is a key section of the speech, with my thoughts interspersed: 

"Looking forward, I believe a more macroprudential approach to supervision--one that supplements the supervision of individual institutions to address risks to the financial system as a whole--could help to enhance overall financial stability. Our regulatory system must include the capacity to monitor, assess, and, if necessary, address potential systemic risks within the financial system. Elements of a macroprudential agenda include:   

• "monitoring large or rapidly increasing exposures--such as to subprime mortgages--across firms and markets, rather than only at the level of individual firms or sectors;"

It is sort of surprising that this has not been done already.   

• "assessing the potential systemic risks implied by evolving risk-management practices, broad-based increases in financial leverage, or changes in financial markets or products;"

Yes, the Fed should not be sitting on its thumb when major financial players leverage themselves up to 30:1 or more (especially if all the off-balance sheet stuff is taken into consideration). Markets evolve and the regulators have to keep up.   

• "assessing the potential systemic risks implied by evolving risk-management practices, broad-based increases in financial leverage, or changes in financial markets or products;"

I'm looking at you, AIG (AIG). There will always be a high degree of interconnectedness between major financial firms. Someone has to be looking at the "what if" cases should one of them go down.   

• "ensuring that each systemically important firm receives oversight commensurate with the risks that its failure would pose to the financial system;"

The devil is in the details here. Given the size of the banking behemoths, each one of them should be treated as a nuclear warhead, and should receive the same level of oversight that we have in regard to our stockpiles of strategic weapons. The problem is that "oversight commensurate with the risks that its failure would pose" would require an incredible amount of micro management.

The solution to that is to make sure that no bank gets big enough to pose such a risk. It is time to break them up, both by function (i.e. reimpose a modern equivalent of Glass-Steagall) and perhaps by region. Ten mini Citigroups (C) would each would not pose an overall risk to the system if one of them were to fail.

Of course you would want to keep an eye on them, just as the military keeps an eye on its 1,000 lb conventional bombs. However, the consequences of one of those going missing is much less profound than a missing nuke warhead.

Unfortunately, in the largely ad-hoc response to the crisis, we have been moving in exactly the wrong direction. JP Morgan (JPM) swallows up Bear Stearns and Washington Mutual, Wells Fargo (WFC) takes over Wachovia, and Bank of America (BAC) now owns Countrywide and Merrill Lynch. All of them were too big to fail before this started, and now they are way too big to fail. Either we regulate them extremely closely -- to the point where they will be complaining that every credit card being issued has to be first cleared with the Federal Reserve Board of N.Y. (OK, I'm exaggerating for effect here) -- or we break them up.   

• "providing a resolution mechanism to safely wind down failing, systemically important institutions;"

This is very important, and is at the core of why all the money that has been poured into American International Group has by and large simply flowed out the backdoor to big foreign banks and Goldman Sachs (GS). If we put them into bankruptcy, it would have been a huge systemic hit to the system, especially coming at almost the same time as the Lehman Brothers collapse.

Without being in bankruptcy, we had to honor the CDS contracts at 100 cents on the dollar. The result was a huge backdoor handout to the banks (a much bigger scandal than the bonuses, IMHO). This would have provided an intermediate step where the new 80% owners of AIG (aka the taxpayers) could have just returned the premiums on the CDS's and rewritten the bonus contracts when we came in.

We can do this with smaller banks, but not with big bank holding companies or huge non-bank financial firms. We need this, and we need it right away.   

• "ensuring that the critical financial infrastructure, including the institutions that support trading, payments, clearing, and settlement, is robust;"

I agree that boring "financial plumbing" stuff is important and has to be maintained. If it backs up, you have one heck of a mess on your hands. This can easily be handled by a sort of boring "public utility" model of banking. Let's get back to the days when banking was a sleepy part of the economy. Low risk, low reward, and bankers were noted for their low golf handicaps. Keep the higher risk stuff (which the economy very much needs) in separate entities.   

• "working to mitigate procyclical features of capital regulation and other rules and standards;"

This is a good point. As things stand now, in good times the value of assets goes up, so the capital ratios look better. In bad times the value off assets goes down and banks become undercapitalized. However, rather than pretending the values of assets don't change (i.e. suspending mark-to-market accounting rules), it would be far better to require financial institutions to build up large cushions in the good times, and allow some more latitude on the capital requirements in bad times.

However, somehow I suspect that as soon as good times come back, the banks will flex all their political influence (they have a lot, as Sen. Durbin (D-Il) said of the bankers and the Senate, "they own this place") so the cushion is never built up in the good times. After all requiring more equity will result in a lower ROE, and that might result in bonuses that are only in the seven figures rather than in the eight figures. The horror, the horror!   

• "and identifying possible regulatory gaps, including gaps in the protection of consumers and investors, that pose risks for the system as a whole."

Yes, although I think referring to them as simply "gaps" is being too generous. We allowed these big institutions to go around and pick who would regulate them. How else would the primary regulator for the world's biggest insurance company end up being the Office of Thrift Supervision (OTS)?

The OTS actively went looking for more institutions to fall under its supervision, and its key marketing policy was that it would be the most toothless and ineffective of regulators. It was the most gung-ho on deregulation, and many of the biggest failures were firms that it was the primary regulator for, including Washington Mutual, Indymac and of course AIG.

We have to find ways to stop shopping around for your regulator and regulatory capture. The Fed would be a very good place to start. It is not comforting that the head of the New York Fed comes from Goldman, and still holds over ten figures worth of Goldman stock when he is now the primary regulator of the firm. That is more than just an appearance of a conflict of interest.

The board of directors of each of the regional Federal Reserve Banks are all made up of bankers. That is because the Federal Reserve is not owned by the government, rather it is owned (literally, not just figuratively) by the banks. Perhaps it is time we reconsider that arrangement. 

The speech is a good start, but it does not go far enough. We need to return to the principals that were behind the financial regulatory reforms of the 1930's. The three-legged stool of good solid accurate information, including of potential conflicts of interest (the SEC), making it safe to keep your money in the bank (the FDIC) and making sure the bank does not take your money and use it to play the tables in Vegas (Glass-Steagall). The precise form will be different than the old regulations, but the new order should embody the same spirit.

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