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Will Financial Reform Avoid Another Economic Meltdown?

Smart Americans have two main questions about the financial industry reforms President Obama promised last Friday: First, will a new Consumer Financial Protection Agency (CFPA) prevent abuse of credit, savings and investment customers (see previous article)? But second, will any proposed regulatory reforms and oversight bodies prevent irresponsible behavior in the financial industry from wrecking the economy again?

This second question should be just as important to you because of the ways the overall US and global economies can affect you personally, regardless of how well you’re being served on your own accounts by the financial industry. This is about keeping your job or finding a better one, access to credit for a new home or a new business, the performance of your investments, the safety of your retirement, the chance your taxes will have to bail out more companies, the level of inflation affecting your purchasing power, etc.

There has been considerable financial deregulation for several decades and ripping up the rules of the road got us into big trouble,” White House economic advisor Austan Goolsbee told MintLife in a briefing last Friday. “Now we’re pushing back against that trend in a way that is smart—not excessive—with more aggressive and robust oversight.”

Minimizing Risk

All of these variables come down to the issues of risk, reform and regulation being debated in Washington this year. After decades of deregulation and don’t-get-caught policies, the Obama Administration and Democratic lawmakers are promising a new era of adult supervision.

“We can’t protect people from losing money if they make a mistake,” he warns, but adds, “We have to have transparency, make the rules clear and get rid of unfair predatory practices.”

Goolsbee points to the need for better oversight in three ways:

1. Some risky activities are missed today because they slip between the supervision of seven different financial regulatory bodies (see below). Subprime mortgages are an example, because only one-quarter to one-third of the loans were being made by regulated deposit-taking banks. The rest were being made by unregulated finance companies.

2. Other risky activities aren’t supervised because those regulatory bodies were set up before these new practices were devised and new laws aren’t keeping up with complicated new innovations in the market. One example is credit default swaps (essentially insurance on debt, or insurance on the insurance, and so on until you don’t even know what you are insuring) which sunk Lehman Brothers and AIG and started the dominos crashing.

3. And finally, new types of financial institutions are growing to gigantic proportions, but then failing through risky activities without a way for government to step in, renegotiate contracts, or liquidate bankrupt company or customer assets when investors’ value goes to zero. For example, the FDIC can do this with banks, but the government had no legal authority to seize Lehman the same way. Without the authority to “resolve” these institutional failures, the government can only throw good money (yours) after bad (theirs).

The Great Depression demonstrated that even private institutions could become “too big to fail” and pose risks to the whole system. So what Goolsbee and the Obama Administration are looking for are ways to improve regulation to avoid those “systemic” risks. Goolsbee divides the issue of systemic regulation into twin tracks: one is how to deal with systemically important or threatening institutions; the other is how to think about emerging systemic threats in the form of new instruments. That is, watching for new financial innovations, such as derivatives trading or credit default swaps that might pose risks to more than just those that invest in them.

Goolsbee admits this is tricky. Not all financial innovations will be good, but not all have to be good for society. “You can’t ban a financial instrument because somebody might make a bad bet and lose their money,” he explains. “The point of the administration’s plan is that we should be concerned about those financial innovations that pose risks to the whole system.”

Centralized Reform

Under current laws, the financial industry is essentially supervised by seven government bodies: the Federal Reserve, Federal Deposit Insurance Corporation, Office of Thrift Supervision, National Credit Union Administration, Federal Trade Commission, Office of the Comptroller of the Currency, and Department of Housing and Urban Development. New proposals call for consumer-related protections to be streamlined and consolidated under one umbrella at the CFPA. The Federal Reserve would continue to set monetary policy and keep responsibility for monitoring day-to-day systemic threats. Meanwhile, the administration also wants a new broad-based “systemic risk council” of financial regulators to watch for emerging or long-term systemic dangers.

“The council is designed to keep an eye on the horizon for the next thing like credit default swaps, to say ‘this is menacing to the system’ and apply higher capital requirements or assign it to be regulated according to some method,” according to Goolsbee. In other words, watching “things rising up that are not within the existing regulatory apparatus, where there is some identification that there are threats to the system, not just to the individual institution.”

“It is imperative that there be a central authority so that there is one set of standards applied across the whole marketplace,” he adds. “The president is committed to addressing issues like systemic risk and systemically important institutions. Somebody should be on them all the time, making sure they have enough capital so they can’t threaten the whole system.”

Again, Goolsbee cautions that even a forward-looking panel can’t regulate based on what every financial innovation might mean for society. You can’t require someone with a financial innovation to document how it would benefit the real economy. “For financial innovations that are brand new that are not systemically threatening in any way, it’s extremely difficult to document the impact of a specific financial product on productive behavior. I don’t know how we would put that in practice,” he explains. “How would we evaluate that? But the standard that is achievable by regulators is to ask, ‘does this product pose a systemic threat to the financial system?’”

“We have got to reestablish rules of the road that form a core of stability for the financial system. That means we can’t allow huge loopholes on anything that is fundamentally about systemic risk,” he says. “So if somebody talks about fundamentally changing rules to allow big systemic risks again that aren’t under anybody’s jurisdiction, or that can squeeze between the regulatory cracks, the president isn’t going to allow that to happen.”

The White House is calling for new “rules of the road” on three levels: protections for individual banking and credit consumers against predatory lending practices, abusive credit card terms, and unfair charges and fees; protections for individual investors against unclear terms and undisclosed risks in their portfolios; and protections for workers and taxpayers against another catastrophic economic meltdown caused by irresponsible practices.

Steve Barth has worked internationally with banks, governments and NGOs on microfinance and economic development. He blogs at Reflexions.