Wednesday, March 31, 2010

Why We Won't Get Major Financial Regulatory Reform

. Wednesday, March 31, 2010

Short answer: there's no political will for sacrificing economic growth and domestic competitiveness. Andrew Ross Sorkin has a piece on the possibility of regulatory reform. It starts off nice and cute -- a chat over cookies with Geithner -- before getting serious:

Conspicuously absent from any regulatory legislation floating around Capitol Hill is the precise level of capital that banks should hold for every dollar they lend, called a capital ratio.

The bill also does not define what can be counted as capital, or how much of that capital should be readily available, known as liquidity. Those questions are being left to the regulators to sort out later.

What does this mean? It means that regulators have no idea what level of capital ratio is necessary to prevent crises, nor what type of capital, nor how much of it needs to be easily accessible at all times. And the stakes are high:

Of course, protecting against even infrequent crises probably means forcing banks to keep a lot of cash on hand in case their bets go bad. But that would come at the expense of economic growth as banks would make fewer loans.

Mr. Geithner insists that if there is one change that needs to be made to the banking system to protect it against another high-stakes bank run like the one that claimed the life of Lehman Brothers, increasing capital requirements is it.

But try pinning down Mr. Geithner, or anyone else in the Beltway, on how much capital banks should be required to keep, or even how the word “capital” should be defined, and certainties disappear.

This really is the crux of the matter. As Greg Mankiw has recently written, we can have a 100% safe banking system. But as Krugman pointed out, it would just require sacrificing a lot of economic growth. And most of that sacrificed growth would be to achieve very, very, small gains in safety (i.e. the relevant margin shifts the further along the safety/growth curve).

Not only that, but if the U.S. unilaterally enacted stricter regulations it would put domestic firms at a competitive disadvantage relative to foreign competitors. So enacting strict reform seems to be a double-whammy: first you sacrifice growth, then you privilege foreign firms over domestic firms. It's easy to see why the Obama administration has been slow to move on this front. Indeed, it seems like they are ready to punt almost entirely:

Instead, the final number is to be determined by a global coalition of regulators known as the Basel Committee on Banking Supervision, Mr. Geithner said.

“By the end of this year, we will negotiate an international consensus on the new ratios,” he said.

This makes all the sense in the world from the Obama administration. If they go through Basel then they'll be able to avoid a lot of the wrangling and lobbying that would occur if reform was debated domestically. Plus, if the new standard is international then American banks won't suffer a competitive disadvantage. Sounds like a win-win for reformers, right? The problem is that the U.S. already has some of the most restrictive prudential regulations in the world. Perhaps that's surprising to many of you, so I'll repeat in italics: The U.S. has some of the most restrictive prudential regulations in the world. Or as Sorkin puts it:

But even then, Mr. Geithner is likely to face a bruising battle, not necessarily from American banks but from their foreign rivals.

“Our major global banks have more capital today relative to risk than do many of their major international competitors,” Mr. Geithner said.

In Europe, banks and regulators focus on risk-weighted capital as opposed to pure capital, allowing those banks to keep significantly less collateral on hand for assets that are deemed not very risky, like ultra-safe Treasury bonds. That’s not the case in the United States.

So as the world tries to harmonize its capital ratios and definitions — a global fix is important so that banks don’t try to arbitrage the system — United States regulators may feel pressure to appease the Europeans by agreeing to lower capital ratios.

Add to that the fact that low capital ratios really weren't to blame for this crisis at all, and things don't look good for regulatory reformers. Don't get me wrong... there will be some sort of reform at the international level through Basel, and something else will happen at domestic level as well, but it won't be the major restructuring of the financial industry that many predicted early in the crisis.


Adarsh Rao said...

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Why We Won't Get Major Financial Regulatory Reform
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