United States Treasury Secretary Tim Geithner and National Economic Council Director Larry Summers jointly wrote an op-ed piece in the Washington Post on Monday, June 15, to lay out the policy goal of the Barack Obama administration's regulatory reform plan to be announced two days later....http://www.truthdig.com/report/print/20090614_the_american_empire_is_bankrupt/.
The essay describes the current financial crisis as "the product of basic failures in financial supervision and regulation", by pointing out that "our framework for financial regulation is riddled with gaps, weaknesses and jurisdictional overlaps, and suffers from an outdated conception of financial risk. In recent years, the pace of innovation in the financial sector has outstripped the pace of regulatory modernization, leaving entire markets and market participants largely unregulated."
Yet the administration's regulatory reform plan is generally viewed as having backed away, due to the political difficulties involved, from a more extensive structural overhaul that would have consolidated all banking regulation into one unified agency.
The op-ed essay identifies "five key problems in our existing regulatory regime - problems that, we believe, played a direct role in producing or magnifying the current crisis".
The essay states: "First, existing regulation focuses on the safety and soundness of individual institutions but not the stability of the system as a whole. As a result, institutions were not required to maintain sufficient capital or liquidity to keep them safe in times of system-wide stress. In a world in which the troubles of a few large firms can put the entire system at risk, that approach is insufficient. The administration's proposal will address that problem by raising capital and liquidity requirements for all institutions, with more stringent requirements for the largest and most interconnected firms. In addition, all large, interconnected firms whose failure could threaten the stability of the system will be subject to consolidated supervision by the Federal Reserve, and we will establish a council of regulators with broader coordinating responsibility across the financial system."
Yet, capital adequacy for large financial firms, while important, will not by itself eliminate systemic risk since systemic meltdown can be caused by massive counterparty defaults on the part of large number of small firms and investors holding structured financed instruments that are off the balance sheets of the big firms to cause insolvency of the big firms.
The problem is that even small firms are now "too big to fail" because of opaque interconnectedness that can cause the system to fail not at its big nodes but at its weakest points throughout the system. The administration's two top economists do not see fit to blame run-away "innovation", only the failure of regulation to keep pace with it. That is like blaming bank guards for bank robbers.
The essay states: "Second, the structure of the financial system has shifted, with dramatic growth in financial activity outside the traditional banking system, such as in the market for asset-backed securities. In theory, securitization should serve to reduce credit risk by spreading it more widely. But by breaking the direct link between borrowers and lenders, securitization led to an erosion of lending standards, resulting in a market failure that fed the housing boom and deepened the housing bust. The administration's plan will impose robust reporting requirements on the issuers of asset-backed securities; reduce investors' and regulators' reliance on credit-rating agencies; and, perhaps most significant, require the originator, sponsor or broker of a securitization to retain a financial interest in its performance. The plan also calls for harmonizing the regulation of futures and securities, and for more robust safeguards of payment and settlement systems and strong oversight of 'over the counter' derivatives. All derivatives contracts will be subject to regulation, all derivatives dealers subject to supervision, and regulators will be empowered to enforce rules against manipulation and abuse."
The non-banking financial system is essentially an anti-banking system in that it allows securitization to convert debt into security; that is, credit into capital. It is an insurgent war against capitalism itself. Pension funds are allowed to invest in debt instruments as if they were security instruments. Such instruments are in reality stripped of security, with returns commensurate with risk levels. The word security is derived from the Ancient Greek se-cura and literally translates to "without fear". Structural finance actually promotes fearlessness that no regulation can negate.
The essay states: "Third, our current regulatory regime does not offer adequate protections to consumers and investors. Weak consumer protections against subprime mortgage lending bear significant responsibility for the financial crisis. The crisis, in turn, revealed the inadequacy of consumer protections across a wide range of financial products - from credit cards to annuities. Building on the recent measures taken to fight predatory lending and unfair practices in the credit card industry, the administration will offer a stronger framework for consumer and investor protection across the board."
Improved consumer protection is certainly needed, but the best way to protect the consumer is to adopt a full-employment economy with rising wages so that workers do not have to assume unsustainable debt in order to buy the products they make.
The essay states: "Fourth, the federal government does not have the tools it needs to contain and manage financial crises. Relying on the Federal Reserve's lending authority to avert the disorderly failure of nonbank financial firms, while essential in this crisis, is not an appropriate or effective solution in the long term. To address this problem, we will establish a resolution mechanism that allows for the orderly resolution of any financial holding company whose failure might threaten the stability of the financial system. This authority will be available only in extraordinary circumstances, but it will help ensure that the government is no longer forced to choose between bailouts and financial collapse."
There is no "appropriate" government mechanism to contain and manage financial crises. The solution is to prevent recurring financial crises. A new resolution mechanism to shift private debt into public debt does little to prevent recurring financial crises. In fact, it may well make such crises routine.
The essay states: "Fifth, and finally, we live in a globalized world, and the actions we take here at home - no matter how smart and sound - will have little effect if we fail to raise international standards along with our own. We will lead the effort to improve regulation and supervision around the world."
US promotion of neoliberal globalization of trade and finance has been the main cause of recurring global financial crises. The lack of international labor standards and wage scales has permitted US corporations to exploit cross-border wage arbitrage that has caused global wage stagnation to generate wage/price imbalance, notwithstanding the essay's misapplied claim of a saving/consumption imbalance. US opposition to international financial regulatory standard has allowed US financial firms to exploit cross-border arbitrage of risk in the name of innovation.
Neither the op-ed essay nor the administration's plan addresses the need for a federal regulatory regime for the insurance sector, which is now governed by state insurance commissions in a tradition of state rights. This issue is particularly central since under-regulated financial risk insurance practices have been a key contributor to run-away systemic risk.
The administration aims to curb excessive risk-taking through reform of structured finance and compensation practices that encourages risk taking, including "say on pay" for shareholders and regulation against abuses of risk induced by short term compensation while leaving the penalty of future loss to shareholders.
Under the Obama plan, the Federal Reserve will retain day-to-day supervision of the largest bank-holding companies, which the George W Bush administration had proposed taking away. The Fed may become the sole regulator for both banks and non-bank financial companies that reach a comparable size and complexity. The Fed is also likely to be given the final authority on bank capital requirements, including a surcharge for the systemically important financial institutions.
However, not all systemic risk powers will be concentrated in the Fed. The Obama plan will propose giving the Federal Deposit Insurance Corporation (FDIC) special resolution powers to wind down important large financial institutions. These powers will extend the capacity of FDIC to manage the orderly failure of a complex financial company, which policymakers hope will mitigate the moral hazard created by recent bail-outs.
Nonetheless, the plan places great reliance on the Fed, which is likely to be controversial in Congress, with critics charging that the Fed had failed to exert its existing regulatory powers over banks in mortgage lending.
Fed chairman Ben Bernanke believes that macroprudential powers (systemic risk powers) may allow a central bank to prevent credit and asset price bubbles not easily addressed with interest rates. But other Fed officials are apprehensive that the central bank is setting itself up for predictable failure, and that the exercise of macroprudential powers will entangle the Fed in political fights that will undermine independent monetary policy-making.
Larry Summers likes to say the Obama administration inherited the financial crisis from the Bush administration, but the Obama plan for regulatory reform essentially inherits the plan of Henry Paulson, the last Treasury secretary in the Bush administration. Paulson advocated consolidation of a regulatory regime "largely knit together over the last 75 years, put into place for particular reasons at different times and in response to circumstances that may no longer exist".
The Geithner plan eliminates the Office of Thrift Supervision (OTS), which oversaw an array of collapsed large institutions such as IndyMac, Washington Mutual and AIG. The OTS is to be merged with the Office of the Comptroller of the Currency (OCC). The shotgun marriage was first proposed by Paulson.
Paulson also wanted to merge the Commodity Futures Trading Commission (CFTC) into the Securities and Exchange Commission (SEC) to ensure that derivatives, the weapons of mass financial destruction, would be properly put under financial arms control. The proposal is not in the Geithner plan, not because the Treasury did not like the idea but because the CFTC, with long historical ties to Chicago, has a powerful lobby. But the SEC will have to devolve some power to a new commission responsible for supervising consumer financial products.
Plans on securitization will force lenders to retain at least 5% of the credit risk of loans that are securitized. Asset-backed securities and the entire over-the-counter derivatives market will face new reporting rules. Large "systemically risky" institutions will have to hold more capital, and
George Soros, the speculator who broke the Bank of England over its defense of the pound sterling, said in the Financial Times that a requirement for lenders selling securitized loans as securities to retain 5% exposure "is more symbolic than substantive". Yet the wider regulatory reform plan has already attracted criticism from bankers who say it will add to the cost of capital.
Republicans are preparing to fight several of the Obama proposals, with lawmakers particularly skeptical about giving more powers to the Federal Reserve, even though much of the Obama plan has been inherited from the previous Republican administration.