Monday, September 7, 2009

Geithner's Plan for Financial Regulation

. Monday, September 7, 2009

No, I haven't read all 600-odd pages. Thankfully, Kevin Drum summarizes:

Basically it requires (a) stronger capital requirements across the board; (b) higher capital requirements for bigger firms, which would make larger firms somewhat less profitable; (c) an emphasis on real capital, not shell games; (d) higher capital requirements in good times and lower requirements in bad times; (e) a simple leverage constraint as sort of a backup to the more complex main capital rules; (f) stronger regulation of off-balance-sheet vehicles; (g) some kind of minimum liquidity requirement so that banks can't be wiped out in just a matter of days by a bank run; and (h) extension of all these rules to big non-banking entities (the "shadow banking" system).


I'm skeptical that (a) and (b) will have the desired effect and may actually encourage more risk-taking; (c) is a by-product of the risk-weighted Basel approach that isn't going anywhere; (d) would be great, transitioning the regulatory framework from pro-cyclical to counter-cyclical, but will be difficult to implement unless we give the Fed much more authority; (e) is logical and feasible; (f) is logical but probably not feasible; i'm not really sure what (g) means; and (h) is a no-brainer.

Alan Blinder likes the proposal but is fearful that the most important pieces will fall by the wayside while the least important pieces are enacted:

Today, the electorate has a vague sense that it has been ripped off and that change is needed. But the sentiment is unfocused and inchoate — with these two exceptions: People clearly want greater consumer protection and restrictions on executive pay.

By no coincidence, those are the two pieces of financial reform that seem most likely to survive the Congressional sausage grinder. Don’t get me wrong; we need both. But the two don’t constitute the entirety of reform, or even its most important parts.


Blinder thinks the three most needed regulations are the creation of a systemic risk monitor, a new process for winding down insolvent financial institutions of systemic importance (i.e. no more Lehman's), and more transparency in derivatives trading. I am in full agreement with the last two, but it's difficult to see how the first could be successful.

In June I wrote what kind of reform I expect to get. Two of the three are in the Geithner plan and the other has been talked about by Congress. I share Blinder's pessimism over what is really feasible once the bills start circulating through Congress. There are a lot of vested interests that will battle against major changes, and I'm not just talking about industry lobbies. It's not clear how much new responsibility the Fed wants, nor how much it should have, and the current fractured system benefits a host of bureaucrats as much as it benefits the banking sector.

Moreover, this issue is complicated and there is unlikely to be any strong public pressure for any specific type of reform (except, possibly, caps on executive pay). The public wants "reform" but it doesn't really know of what sort, so industry groups and entrenched regulators should be able to tweak any legislation to their advantage. If Congress is to focus on just one thing, it should be transparency: for derivatives trading, for ratings agencies, for regulators, for leverage ratios. A more heavy-handed approach may bring more trouble than good without solving the underlying problems.

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Geithner's Plan for Financial Regulation
 
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