Muwabi Economic Forum

Financial Reform

The news has largely been dominated by Obama’s plan to reform the financial system through new regulations. The plan has received a lukewarm reception from Congress, as they are finally beginning to question the role of the Federal Reserve in this crisis. I’ve posted my feelings about the Federal Reserve and believe it should be audited and either marginalized or eliminated altogether. It amazes me that an institution comprised of the so-called brightest financial minds could miss the real estate and credit bubble and the consequences it would create. As a banking regulator and economic forecasting group, it’s inconceivable that they could ignore the obvious risks to the economy. Many have said this was unpredicatable, but this is merely an excuse for the speaker’s own incompetence. Plenty of people predicted this exact crisis, but it was apparently too tough for the all-wise Federal Reserve. My theory is they were so busy helping create the bubble by keeping interest rates unnaturally low and encouraging the real estate boom that they fell for their own manipulations.

Amazingly, the Fed has been granted with unprecendented levels of power and expanded their balance sheet to unimaginable levels. If this wasn’t enough, the new Obama plan wants to actually increase their regulatory power. After the Fed nearly brought down the economy with their own regulatory ineptitude, they’re being given even more responsibility. I’ve often compared this to bringing Donald Rumsfeld back to manage the Afghanistan surge and our problems with North Korea. How about a financial example of bringing Bernie Madoff back to run TARP? You get the point…

Fortunately, this isn’t the only provision of Obama’s reform. Some of his proposals are actually quite good, while others fall short. Here’s a summary of the plan from the AP and my initial response:

Highlights of Obama’s financial reform plan

A look at President Barack Obama’s plan to improve oversight of the financial industry:

–Creates a council of regulators called the “Financial Services Oversight Council” to monitor risk across the financial system. The council will be chaired by the treasury secretary and include the heads of existing federal financial regulators, the Federal Reserve among them, and representatives of new regulators.

I don’t really see this being effective at all. I hope the regulators already meet regularly and can agree upon a consistent approach to regulating the economy. If the past can predict the future, however, agency heads will battle for turf and influence rather than cooperating on critical issues.

–Establishes a Consumer Financial Protection Agency to protect consumers from deceptive practices by such companies as credit card lenders and mortgage brokers.

While I have no problem with a government agency actually looking out for the consumer for a change, I’m wary of their punitive powers. What exactly constitutes deceptive practices? These should be clearly defined and should consider the business perspective for instituting this behavior in the first place. For example, a bank hiding fees on page 36 of the size 4 font disclosure is deceptive and should clearly be regulated. A bank enforcing normal, clearly disclosed fees like overdraft should be allowed to run their bank as they choose. As long as banks aren’t abusing customers, this agency should let them do their business. Customers will avoid bad banks on their own cognizance.

–Gives new authority to the Federal Reserve to supervise firms considered so big or influential that their failure could topple the economy.

Even though I disagree with the Fed doing the regulating, I like this provision. I’d like more detail, however, because you don’t want to risk over-regulating our most important financial institutions. It’s also important to ensure certain companies aren’t being singled out and treated differently than others. This is both unfair and unconstitutional. I don’t mind companies getting bigger as long as they’re doing so competitively and with legal methods. The one regulation these companies need is to simply stop leveraging at excessive levels (in my opinion 2 or 3-1 but lets get back to 12-1 first). If we take leverage risk out of the equation, the companies can focus on prudence and maximizing their core business. All in all, this could be a good provision if “supervise” implies a knowledge-gathering power. Given the Fed’s track record, however, I can see them using their powers in the worst way.

–Creates a system to dismantle a troubled firm. Once the Fed and the Treasury Department decide an institution is a threat to the economy, the Federal Deposit Insurance Corp. would step in to break it down and sell its assets with minimal impact on investors.

Again, more details please. What are the signs of being a threatening institution? The government should not legally be allowed to intervene in a private institution’s business unless they’ve failed. I think the existing FDIC receivership rules are sufficient to make that determination. This one really makes me nervous.

–Establishes a National Bank Supervisor to monitor all federally chartered banks and federal branches of foreign banks. The Fed and FDIC would retain their existing roles in helping to supervise state-chartered banks.

I think this is just the OTS with a new name. Such an agency is obviously necessary, but I hope the failures of the OTS are cleansed from this new agency.

–Eliminates the Office of Thrift Supervision. Critics say the office’s oversight of American International Group and IndyMac was too lax and contributed to their demise.

Finally a little accountability for institutions having failed so badly!

–Retains the Securities and Exchange Commission and Commodity Futures Trading Commission as market regulators. However, the SEC would no longer have a role in supervising large holding companies as it did in monitoring Lehman Brothers and Bear Stearns. That role would be turned over to the Federal Reserve.

I’m happy to see the SEC and CFTC being kept separate. Whoever regulates the large holding companies is irrelevant…both dropped the ball and should clean up their internal processes. I still prefer the SEC keeping this regulating power, however, because I don’t think the Fed should exist.

–Gives the SEC oversight of hedge funds and other private pools of capital, including venture capital funds.

This has been needed for a long time. Possibly the best part of his proposal. I just hope it’s executed well.

–Requires financial institutions to retain more capital when making risky investments.

Define risky investment? I think capital requirements should be significantly raised across the board, but want to see them take that extra step. I think Obama missed the opportunity to go further on this proposal but it’s better than status quo.

–Calls for regulation of “over-the-counter derivatives,” such as the insurance-like contracts that felled AIG. The plan leaves in question who would regulate them.

I have a big problem with this one… it’s simply the wrong approach altogether. These are extremely complex investment and the market has a right to greater transparency. As an investor, I am left with little additional comfort that they’re being “regulated”. Derivatives need to be traded on a public exchange where a standard level of collateral and disclosure is required. I think many of the derivatives were innovative financial products, but were mismanaged because investors had no insight into their contents and firms posted minimal reserves against losses. Much greater thought needs to be put into this proposal, rather than simply handing the problem to an unknown regulator.

–Aims to deter lenders from writing bad mortgages and passing the risk off to investors by requiring that lenders retain a 5 percent stake in all asset-backed securities.

I’m really 50/50 on this one. I think the better alternative is to create better disclosure practices on ABS so investors can make better decisions. The best way to do this is eliminating the credit ratings pay scheme (see below) so ratings are more reflective of true risk. At the same time, I do understand the need for aligning risk. Since 5% is relatively minor, I don’t have a problem with this but would still prefer the plan to be more effective.

–Requires that shareholders get to vote on compensation packages for financial executives.

This isn’t getting much attention but is a great way to solve the problem of excessive executive compensation. I’ve been worried about the government trying to impose limits on compensation, but am happy they’re leaving it to the owners to decide. Like annuals votes on retaining the CEO, I expect it will have little impact because most votes are controlled by the Board of Directors. At least it increases participation from shareholders and holds executives accountable for poor performance. I’m interested to see more details about this provision.

–Creates an office within the Treasury Department to review the regulation of insurance companies, now done primarily by states.

–Calls on the Treasury Department and the Housing and Urban Development Department to make recommendations on the future of government-backed mortgage lenders Fannie Mae and Freddie Mac and the Federal Home Loan Bank system.

Good stuff on both of these… I’d prefer this was done through independent commission (I’m a big fan of those) but I like investigation and deliberative thought before major decisions are made. I think the rest of these proposals lacked much force or insight and would prefer the entire reform be independently crafted (perhaps put Paul Volcker as chair). Of course this is wishful thinking, but it adds much more credibility to the equation. I think many of these provisions will be changed substantially because I don’t think Democrats or Republicans support it in its current form.

Finally, let me post a few good links in response to the reforms. First, Barry Ritzholz offers his intial thoughts (which I think are almost spot on):

Obama Reform Plan Fails to Fix What’s Broken

Second, a good Washington Post article about the Congressional response to Obama’s proposal. I loved reading this article because of all the great Federal Reserve criticism!

Lawmakers Balk As Administration Tries to Redefine Central Bank’s Role

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5 Responses to “Financial Reform”

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