Can Finance Be Fixed?

Financial reform efforts are running into trouble in the U.S. and Europe.


As the global financial system teetered on the brink of collapse in September 2008, policymakers and regulators around the world responded with unprecedented speed and boldness. They injected hundreds of billions of dollars of capital into financial institutions and extended trillions of dollars worth of debt guarantees, effectively declaring that no more major banks would fail. In addition to those short-term remedies, they promised to undertake sweeping regulatory reforms to tighten control of financial institutions and put an end to the culture of loose credit, lax oversight and distorted incentives that many have blamed for causing the turmoil.

“We need to prevent a crisis like this from ever happening again,” Treasury Secretary Timothy Geithner said in unveiling the Obama administration’s reform proposals.

But one year after the collapse of Lehman Brothers Holdings, efforts to overhaul the financial system to make it safer and sounder have run into serious trouble. Geithner’s draft legislation for strengthening regulation has generated stiff opposition from members of Congress, the financial services industry and even several regulatory agencies since it was introduced in June. The disputes range from matters of turf — should retail products be regulated by a new body, as the administration proposes, or by existing agencies? — to questions of principle, such as whether giving the Federal Reserve Board and its recently renominated chairman, Ben Bernanke, expanded powers to oversee systemic risk and the largest financial institutions will concentrate too much authority in the central bank and compromise its ability to conduct monetary policy.

“I see all the big banks that failed. They were mostly regulated by the Fed,” says Senator Richard Shelby of Alabama, the ranking Republican on the Senate Banking Committee and a leading opponent of an expanded Fed role. “I think the Fed ultimately failed the American people.”

A revival of the fortunes of many banks, meanwhile, has emboldened industry opposition to key elements of the proposals, including recommendations to impose significantly higher capital charges on the largest banks. The Obama administration and European Union officials argue that the biggest firms should hold more capital than other banks because their failure can be so costly in terms of public bailouts. As Jacques de Larosière, the former French central banker and onetime International Monetary Fund boss who authored an EU report on reforming bank supervision, puts it, “The bigger you are, the more connected you are, the more you pay.”

But the Washington-based Institute of International Finance, a lobbying group for major global banks, warns that raising capital ratios too high or too quickly could stifle bank lending at a time when policymakers are seeking an economic rebound. “You could end up taking several percentage points off GDP growth,” asserts William Winters, co-CEO of the investment banking division of JPMorgan Chase & Co. and a member of the IIF’s board of directors.

In the U.K., industry opposition prompted the country’s Financial Services Authority to water down new rules on compensation last month. The FSA, like other regulators, argues that the promise of hefty cash bonuses encouraged bankers to make big bets in search of short-term profits in areas such as subprime mortgages without accounting for the risk that those positions could blow up. The authority’s new rules seek to tie pay more closely to risk and ban guaranteed bonuses of more than one year, but the FSA abandoned proposals floated earlier this year to require banks to defer two thirds of bonus payments and link them to company performance. The regulator said it was responding to industry complaints that tougher rules “could have adverse competitive implications for the U.K. as a financial center.”

To those who believe that banks’ ability to arbitrage among competing regulators contributed to the crisis, the FSA’s climb-down on pay was a worrying sign. “I was disappointed to see that they felt they needed to do that,” says Sheila Bair, chairman of the Federal Deposit Insurance Corp. (see article, " FDIC’s Sheila Bair Affirms Agency’s Role ”). With Goldman, Sachs & Co. announcing a jump in compensation expenses that could see the average employee’s pay more than double this year, to $773,000, and Citigroup seeking an exemption from federal pay guidelines so it can hand a $100 million bonus to commodities trader Andrew Hall, Bair warns that “we are getting back into some bad behaviors” and argues for principles-based rules to link pay to long-term performance and discourage excessive risk-taking.

Many reform advocates are dismayed by what they see as a waning appetite for change. Raghuram Rajan, a professor at the University of Chicago’s Booth School of Business who issued prescient warnings about the risks of complex financial products while serving as chief economist of the IMF earlier this decade, says he is “very pessimistic” about the prospects for meaningful reform. He believes that the kind of capital increases officials are proposing fall well short of what’s needed. “The crisis was deep, but it seems to have abated enough for the pressure to think creatively to have worn off,” he notes.

Says William White, former chief economist of the Bank for International Settlements, the Basel-based organization that is helping to coordinate global reform efforts, “It is not right to have firms that are too big to fail.” The problem is only getting bigger, he contends, because of the emergence from the crisis of an elite bracket of major firms, led by Goldman Sachs and JPMorgan, and the widespread assumption that governments won’t let those firms go bust.

“It’s worse now than it was before,” White asserts. “We’ve got a few really dominant firms globally. There doesn’t seem to be the political will to attack this head-on.”

Government officials on both sides of the Atlantic insist they remain fully commited to a far-reaching regulatory revamp.

U.S. Deputy Treasury Secretary Neal Wolin expresses confidence that Congress will by the end of this year pass a comprehensive bill incorporating the administration’s key proposals — including creation of a systemic risk council to monitor systemwide rather than bank-specific dangers, tightening of capital requirements, regulation of derivatives and establishment of new consumer protection rules.

“We want to make sure that we don’t go back to business as usual,” says Wolin, a former Clinton administration legal adviser and, until January, a top executive at Hartford Financial Services Group.

In Brussels the European Commission plans to issue legislative proposals this fall for establishing a European Systemic Risk Council, establishing legal authority for winding up failed banks and increasing capital requirements for lenders. “There is still quite a determination to put some order in here,” says one senior EU official.

And officials are well aware of the need to act as quickly as possible, while the severity of the crisis is fresh in people’s minds and political support for fundamental change is strong. “We have to do the reforms properly, but we should not wait,” avers Jaime Caruana, general manager of the BIS. “There is now a window of opportunity because of the crisis, and we should take advantage of this window.”

U.S. and European authorities are pursuing broadly similar reform plans thanks to intensive cooperation since the outbreak of the crisis. The Financial Stability Forum, a group of top regulators from the major industrial countries that was formed in the late 1990s after the Asian financial crisis, set the reform agenda when it identified the chief causes of the most recent calamity and made recommendations for change in April 2008: Banks were overleveraged and require more capital and closer supervision; compensation should be tied to long-term performance, not short-term profits; the originate-to-distribute system of securitization needs a major overhaul to improve underwriting standards and transparency; credit rating agencies should meet higher standards and eliminate conflicts of interest in advising on and rating structured products; and the industry should standardize over-the-counter derivatives to contain risks.

At a meeting in London this past April, leaders of the Group of 20 nations adopted an action plan that promised to enact most of the FSF’s recommendations. The leaders also agreed to extend regulation to all systemically important financial institutions and markets, including hedge funds, and to overhaul regulatory systems to monitor macroprudential risks, or dangers to the entire financial system rather than to a single bank or brokerage firm. In addition, the G-20 expanded the FSF into the Financial Stability Board, with a mandate to coordinate global reform efforts and work with the IMF to provide early warnings of future crises (see article, “IMF Enjoys Newfound Respect”).

These reform promises, combined with G-20 pledges to triple the IMF’s lending resources to some $1 trillion, have played a key role in restoring confidence in the financial system, policymakers and analysts agree. “The clear message coming out of the London summit was: ‘We get it. We get the magnitude of the challenge, and we’re going to act. In fact, we’ll do whatever it takes,’” says John Lipsky, the Fund’s first deputy managing director.

A sharp rally in financial stocks in recent months, driven by a positive reaction to the U.S. Treasury’s stress tests of major banks and the early repayment of Federal bailout funds by institutions such as Goldman, JPMorgan and State Street Corp., has encouraged some analysts and investors to believe that the industry, and the economy, are well on the road to recovery. Regulators continue to urge caution, though. It took many years of low interest rates, soaring asset prices and investor underpricing of risk to trigger the credit crisis, and it will take a long time for deleveraging to run its course.

“Anybody who argues that the crisis is over doesn’t understand what’s been going on for the past ten years,” says one European central banker, who spoke on condition of anonymity.

Regulatory reform is a key part of the healing process. The Obama administration’s proposals, as well as similar measures unveiled by the U.K. government in July and ones due to be put forward by the EC this autumn, represent a decisive break from the free-market liberalization that had held sway in financial markets since the Reagan administration in the early 1980s. Advocates of reform say that’s precisely the point. The financial crisis “followed a period of 15 or 20 years of deregulatory cant where the investor was surely disadvantaged by the power and cohesiveness of business groups that persuaded Congress we were an overregulated society,” says former Securities and Exchange Commission chairman Arthur Levitt Jr.

Enacting reforms was never going to be easy. The demand to increase safety and reduce leverage in the financial system sits in open conflict with the political desire to see banks increase their lending to spur the economy. Regulatory agencies and their legislative overseers are eager to protect their turf, a leading reason that the Obama administration declined to propose a consolidation of the SEC and the Commodity Futures Trading Commission.  And notwithstanding its tarnished reputation, the financial services industry remains one of the most powerful, well-connected lobbying groups.

“Large banks are useful to the economy and business,” Deutsche Bank CEO Josef Ackermann wrote in a recent column in the Financial Times. “As we move forward in our quest to make the global financial system less prone to crises, we would be well advised to bear this in mind.”

Such arguments explain why U.S. and European officials early on discarded bolder reform ideas, such as the reimposition of Glass-Steagall barriers between commercial and investment banking or the forced breakup of institutions deemed too big to fail.

Paul Volcker, the former Fed chairman and sometime adviser to President Barack Obama, told a recent gathering of bankers at an IIF conference in Beijing that it was “unwarranted” for banks funded by taxpayer-protected deposits to “be engaged in substantial risk-prone proprietary trading and speculative activities that may also raise questions of virtually unmanageable conflicts of interest.”

Similarly, Mervyn King, the governor of the Bank of England, called earlier this year for a public debate on separating the deposit-taking activities of banks from “the casino trading of an investment bank.” But key policymakers, led by Geithner and head of the National Economic Council Lawrence Summers, who led the repeal of the Glass-Steagall Act as top Treasury officials in the late ’90s, contend that big universal banks are too central to today’s financial system to be taken apart. “My ideal world would be the kind where banks take deposits and make loans,” says the FDIC’s Bair, “but the genie is out of the bottle.”

Instead of forcing structural change in the industry, officials are hoping to constrain excessive risk-taking and avert future crises through tighter capital controls and closer supervision. Geithner’s reform proposal would apply the strictest capital rules to so-called tier-1 holding companies, or financial firms so big and so interconnected that their failure would pose a threat to the stability of the financial system. In addition, the plan would grant the Federal Reserve expanded powers to supervise those firms.

Officials maintain that the new requirements will be costly and act as a strong disincentive for banks to undertake the kind of leveraged, high-risk activities that led to the financial crisis. “Firms are not going to want to be designated as tier-1 holding companies,” says Michael Barr, the Treasury’s assistant secretary for financial institutions.

The intention seems clear, but many industry observers question whether regulators will deliver. Most of the new capital rules will be decided not by governments but by the Basel Committee on Banking Supervision, a BIS sister organization. In July the committee published revised rules raising capital requirements for banks’ trading activities and off-balance-sheet exposures and laying out guidelines for banking supervisors to adjust capital requirements according to banks’ risk management practices.

Supervisors will test the impact of the new rules over the next year and may amend them before they are implemented, by the end of 2010. Earlier this decade big banks took advantage of similar tests to lobby successfully for an easing of the Basel II capital standards, and they have begun taking aim at the new rules.

The banks argue that although the case for individual capital-tightening moves may be sound, the cumulative effect would raise requirements excessively for big banks with broad activities and large trading operations. “The impact is material,” says JPMorgan’s Winters. The new requirement for securitizations is particularly onerous, he contends, with some banks likely to face capital charges of as much as 100 percent for collateralized debt obligations of asset-backed securities. Such costs, he adds, would effectively snuff out attempts to revive the securitization markets, which policymakers regard as vital to restoring credit for consumers and businesses.

The Basel Committee is also considering measures to require banks to build up capital buffers that can be drawn on to cover losses in a crisis. The aim is to reduce the procyclicality of the current system, which allows banks to operate with relatively little capital in boom times — thereby fueling credit expansion — and then forces them to raise capital sharply during a bust, just when it is most scarce.

The BIS’s Caruana led the Bank of Spain in implementing such a system, also known as dynamic provisioning, when he was governor of the central bank in the first half of this decade. Many regulators credit the technique with leaving Spain’s big banks relatively untouched by the global crisis. But requiring banks to set aside reserves for loans before any impairment occurs would fly in the face of mark-to-market accounting standards.

So far regulators have refused to project what the net impact of the various rule changes will be on overall capital levels, except to say that increases should be phased in over perhaps three to five years to avoid any diminution of lending in the short term. “We should not overdo it,” says Caruana. “We should find the right balance.”

Banks currently are required to hold capital equal to 8 percent of their risk-weighted assets, of which half must be core, or equity-type, capital. University of Chicago’s Rajan predicts a compromise increase of a couple of percentage points, offering some greater margin of safety but still leaving banks vulnerable to the tail risk of a major crisis. “The levels of capital that would really deal with the problem are just too high to have a profitable industry,” he explains.

Just as controversial as the suggested capital requirements is the administration’s proposal to put the Federal Reserve in charge of overseeing systemic risk and supervising 20-odd major institutions whose failure could spark a broader financial shock. Some believe that the Fed should be out of consideration because of past mistakes. Senator Shelby criticizes it for inadequate oversight of troubled banks like Citigroup and for its role in leading the bailout of insurance giant American International Group. Senator Christopher Dodd of Connecticut, the Senate Banking Committee chairman, tells II the Fed had an “abysmal performance” in letting the subprime-mortgage industry grow out of control. Both senators say they lean toward giving systemic oversight responsibilities to a council of regulators including members from the SEC, the FDIC, the Fed and other agencies.

Having a systemic regulator is one thing. Having that regulator perform the job effectively is another. So far it remains unclear whether any regulator will be up to the task.

Officials have sketched out broad principles behind so-called macroprudential supervision: Focus on linkages between financial institutions rather than on individual firms, and between financial markets and the economy. Interconnectedness, not sheer size, is the key. But it’s far from clear how anyone should use that concept to nip a future crisis in the bud. The fact that regulators failed to spot the systemic risk in AIG’s massive portfolio of credit default swaps until it was too late suggests a need for skepticism in any assessment of a regulator’s crisis prevention capabilities, acknowledges one European central banker. The Fed, moreover, continues to reject the idea that it should try to restrain the growth of credit or prevent asset-price bubbles from developing, a stance that many analysts believe contributed to the crisis.

Former IMF chief de Larosière acknowledges the skepticism but defends the new approach. “I can’t demonstrate that a macroprudential oversight system would have avoided the crisis,” he explains. “But what I can say for sure is that the absence of a prudential risk council, and toothless warnings, have done nothing to avoid this crisis.”

Much the same could be said for the broader regulatory reform agenda. Investors and taxpayers had better hope that policymakers are making the right choices.