American ExpressAmerican ExpressAmerican ExpressAmerican ExpressAmerican Express
United StatesChange Country
Business Class

May 14, 2009

Size Matters: Financial Regulatory Reform that Works

Size Matters: Financial Regulatory Reform that Works

John Carney

Managing Editor - Clusterstock, Business Insider

Summary

Nearly everyone agrees that when we emerge from the current economic downturn, we’ll have to turn our attention to reforming the financial s

Nearly everyone agrees that when we emerge from the current economic downturn, we’ll have to turn our attention to reforming the financial system. The bad news is that the emerging consensus about how to reform the banking system risks recreating the very problems that got us into this mess in the first place. The good news is that there is a better way.

At first glance, it looks like the breakdown of our financial system happened suddenly. Things looked to be humming along nicely until—Kaboom!—investment banks started collapsing, the FDIC found itself seizing banks by the dozens, and the role of government went from regulating the financial markets to rescuing them.

The reality is that the problems with the financial system and the regulatory structure that was supposed to prevent disaster, protect investors, and keep the economy in balance go much deeper and have been metastasizing for far longer than the last few years. They stretch much farther back than just the recent housing boom that made so many Wall Streeters so rich and can’t be reduced to something as simple as deregulation.

It’s tempting to blame the collapse on deregulation. The government was mightily solicitous of Wall Street for the last few decades, beginning with the election of Ronald Reagan but stretching through Bill Clinton and both George Bushes.  Wall Street got its way on many issues: rules about leverage and capital were relaxed; creative accounting was tolerated even after Sarbanes-Oxley; and Glass-Steagal’s wall of separation between investment banking and commercial banking was torn down. It sure looks as though there was a lot of deregulating going on.

There’s also something psychologically satisfying about blaming deregulation. It implies that if only we hadn’t deregulated, we could have avoided the current crisis. In a sense, it simplifies the chaos around us by pointing to a rather simple, identifiable cause of our problems. And once the cause is made legible, we think we can easily write the answer: bring back regulation.

As persuasive as this might sound, it really is too simple. The seeds of the breakdown of the regulatory structure were actually planted way back in the 1930s. Following the Crash of 1929, the Senate banking committee convened a series of hearings meant to find out what went wrong on Wall Street. The hearings dragged in the heads of finance and produced a stark picture of misdeeds and corruption. Once they were concluded, lawmakers and the broader public had a road map for reform.

After the New Deal era reforms were put in place, the reformers were mostly worried that someday they’d be removed.

“We may now need to be reminded what Wall Street was like before Uncle Sam stationed a policeman at its corner,” Ferdinand Pecora, the former New York Attorney General who acted as lead counsel for the Senate banking committee hearings wrote in 1939, “lest, in time to come, some attempt be made to abolish that post.”

The reformers didn’t notice that the grand regulatory structure they had built to reduce risk to the economy from high finance was the source of risk in another area: it was corrupting the political process. After the reforms were in place, Wall Street and Washington were drawn into an ever cozier relationship. Regulators were literally placed in offices inside of banks. Bankers had regulators on speed dial. Just look at then-New York Fed President Tim Geithner’s schedule (obtained by the New York Times this week after a Freedom of Information request): he was constantly meeting with top bankers.

In many ways, the structure was corrupt from the get-go. Regulations froze Wall Street’s familiar structure in place, preventing small up-starts from challenging the big guys. Many of the reforms seemed to do more to encourage investor confidence than actually protecting investors from sharp practices. In any case, they did little to stem the growth of finance’s power in American life.

Wall Street’s cozy relationship with Washington was not, primarily, directed at deregulating the financial sector.  If it were, deregulation would have been swifter and more complete. Instead, it was directed at manipulating regulation—strengthening some rules, reshaping others, diminishing still others—in a way that favored the profits of the big firms and the paydays of those that ran them.

The main lesson from the failure of the New Deal financial reforms should be that we need to create a system less susceptible to regulatory capture. Unfortunately, most of the reforms proposed by mainstream policy makers would do just the opposite. A unified, active financial regulatory agency, for instance, would be far more susceptible to capture than a regulatory regime divided between among a variety of agencies.  Novel and complex regulatory structures and rules that simply cannot be understood by the public, ironically, will further empower Wall Street.

So does this mean hope for financial regulatory reform should be abandoned? Perhaps. The prospects are bleak. But one type of reform might offer hope.

The best prospect for a workable financial reform would be a simple ban on financial firms from becoming too large. It almost doesn’t matter exactly how we do this or how big we decide is too big. The correct size might be fifty billion dollars of assets, or a hundred billion of assets. What really matters is just setting the rule and sticking to it no matter what, forcing the break-up of any company that crosses the line.

You can think of it as a kind of anti-trust rule for the financial sector. But probably a better analogy is to a flat tax. By forcing a one-size fits all, universally applicable rule with no exceptions, we’d greatly cut down on the ability and incentive for manipulation by financial firms.

This wouldn’t prevent stupidity, corruption, or failure in the financial sector. But it would reduce the costs of these problems. It will also help clean up our politics, instead of making them even dirtier. And that’s the key to a successful reform—reducing our expectations that some technical regulatory fix can ameliorate permanent human moral failings.  Once we stop trying so hard to improve the world, we might find that we can simply improve our ability to protect our defenses against the world’s dangers.