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Saturday, March 29, 2008

Proposed Financial Regulator Changes

It sounds pretty sweeping, although the reporting varies a bit. (See also the CR post which links to the very detailed NY Times article.)

Combining thrift (OTS) and national bank (OCC) supervision makes sense, given their agencies' recent assertions of similar powers and the lack of state regulation. Also, OTS seems to have several disasters on its hands.
The proposal would designate the Fed as the primary regulator of market stability, greatly expanding the central bank's ability to examine not just commercial banks but all segments of the financial services industry.
Few people outside the industry realize this, but most of the enforcement muscle the regulators assert derives from the "safety and soundness" rubric. This seems as if the regulators are acknowledging that a new industry-wide (rather than institution-specific) standard of safety and soundness needs to be addressed in the wake of the repeal of Glass-Steagall. That does make sense.

Two major changes:
In other areas, the Fed gathers more power. The study proposes that the Fed become a ``market stability'' regulator, with powers over insurance companies and securities firms with federal charters.

The study also suggests a distinction be made between the Fed's ``normal'' lender-of-last resort discount window to help banks meet short-term funding needs and ``market stability'' lending to help stave off severe funding shortages and panics. In that function, the loans could be extended to federally- chartered insurance companies and financial institutions, the study says.
But again, all of this addresses problems that arose as the result of repealing Glass-Steagall's walls between various functions. When the distinction between commercial banks and investment banks is eliminated, the incentives for tying become intense, and when financials can own insurance companies, etc, a vast new group of risks emerge.

Barring a second Great Depression, it's hard to see how we can unscramble the financial eggs that Glass-Steagall's repeal scrambled. But no one really knows how all this will work, and so far I have not read of anything that would address the role of the ratings firms. Failure to address that risk essentially makes most of these other changes meaningless.

The ratings firms (such as S&P, Moody's and Fitch) have been granted authority by the financial regulators to grade the soundness of investment vehicles of various types. The financial regulators take collateral, figure risk costs, etc, using those ratings. Since the failure to correctly assess risk was widespread, this needs to be addressed.

The complexities of the current environment continue to mount. Here's an example. The FRB just released an interpretation ruling that a credit card bank can now underwrite (versus selling for an unaffiliated third party) debt insurance for its credit card customers without a change in status.

Consider the risks. Insurance companies are generally regulated by their state insurance regulator, and for an insurance company to sell insurance in a particular state it has to comply with that state's regulations, fees, etc. Regulator scrutiny includes investigation of the company to ensure that it has adequate investments to pay off claims under foreseeable circumstances.

If you allow a credit card bank to effectively get into the insurance business, it aggregates risk. Rather than having a separate counterparty to turn to when the economic environment goes bad, the credit card bank would have to turn to its own reserves. Needless to say a downturn in economic environment jacks up CC defaults. It always has and it always will. So now the credit card bank will be paying off claims to itself.

Think about that. There really is no insurance here unless the CC bank itself calculates everything correctly and builds up sufficient reserves to handle it. Who will be responsible for ensuring that it is doing so appropriately, and that it is not using the insurance reserves as required risk-based capital reserves?

From the details discussed in the letter, there's also an issue of business practices. If, during a period of involuntary unemployment, the only real benefit to the customer is that the bank won't dun them for payments, but they won't be able to use their cards and interest will still accrue, one wonders about the appropriateness of the service. Debt under the program only gets cancelled when the borrower dies.

The current situation is genuinely bad, but I wonder if we are on the path to better financial management? I am not convinced. Oh, banks will draw back their mortgage lending standards to something approaching rationality, which will help. But there are other problems out there, and the consumer's debt burden is a huge economic issue.

The current situation is genuinely bad, but I wonder if we are on the path to better financial management? I am not convinced.

Me either... so what comes of this? Any guesses?
Well, the truth is that unless you do substantially repeal Glass-Steagall, which is probably not possible, we do need a much enhanced regulatory framework.

I can't guess at the outcome. I am reading the long version and thinking.

I doubt this will be sufficient, to be honest. I think you would need a much-enhanced federal structure with a lot more resources to keep control of the bucking bronco.
My first thought is we move to an era of lower leverage, and lower growth. Better for the the average American, and hurts the gunslingers trying to play the asymmetrical option into Billionairehood. At the end of the day, it's greed that's caused these problems.
Yes it is!!! The imbalance between financial profits and fundamental production can't remain as is.

I expect we will all be alive at the end of this, but I am not sure we can confidently assume that the lessons will have been learned. The stability of a banking system is based on risk recognition. I'm not sure we are getting there.

I realize, CF, that we cannot now try to disaggregate the financials. There is no easy way back. But if we continue to allow these complicated operations and don't institute a greatly expanded system of regulation, I bet we'll have rolling crises in the banking system similar to those of the 1800's, and the economy will be more volatile.

Is it significant that Hillary's new campaign manager, Margaret “Maggie” Williams, used to sit on the board of Delta Financial Corporation, a now-bankrupt sub-prime mortgage lender?
Given the slime from which this plan arises, it makes a lot of sense.

After all, it is far more efficient to not regulate with one agency than it is to not regulate with 6.

More seriously, I believe that absolutely nothing should be done with the current administration in place. They have proven their incompetence and corruption in everything they have touched.

I realize, CF, that we cannot now try to disaggregate the financials. There is no easy way back.

Might it not be easier to un-repeal Glass-Steagall than to try and keep this aggregated mess safe? Is there any way to comprehend the entities lately created well enough? Glass-Steagall worked for 60+years! As for it not being "easy", nothing leading from here is easy. If some IBs get bruised while we unscramble the egg, too f'in bad. They've got it coming.

Different topic:

I was watching CNN's "Ballot Bowl" and someone asked Obama (this was on Friday or Saturday) what he thought of the proposals and he actually said that they did not go
far enough to regulate the newcomers at the FRS's trough (using other words obviously). I was amazed to hear a cndidate actually understand that much. (I may have alreday posted this here on another thread. If so, sorry!)
Bob, first, these are changes Congress would have to make. This is not something that can be accomplished before the changeover in January regardless.

I think you are displaying some unreasoned prejudice, but that could be my blind spot, I suppose. May I recommend John Mauldin's Outside The Box newsletter?

The current situation has been over 15 years in the making.

I feel strongly that after having taken down the firewalls of Glass-Steagall, we will need a greatly enhanced regulatory system. Many people are claiming that less regulation is needed. I say events have proved them wrong. However, no president will make this decision. It is Congress that has the legal authority to make most regulatory decisions. It is their authority under the Constitution that constituted the Fed and these other bodies.

For years I have been asserting that Congress needs to act. It seems to me that they are reluctant to do so, claiming that they have already given the Fed the authority. But I believe that is an unconstitutional claim, and the latest attempt at Reg Z reform is pitifully inadequate, yet it may exceed the Fed's current authority.

My belief is that risk assessment in this atmosphere requires a third party which does not make its money from for-fee rating. It could be set up with a small tax, a la the FDIC insurance fees banks take. But it must be done before any regulatory reform will work.

Failure to do so post GLB will doom any type of reform. Regulatory reform is urgently needed, but it must be grounded on accurate risk recognition.
Bob - if things totally crash, I would agree with you. However trying to disaggregate without that crash would probably cause one.
I think you are displaying some unreasoned prejudice,

To observe that Bush admin is ciorrupt and incompetent is just to state reality.

Congress may have to do this, but they should do it from a clean slate, completely ignoring anything from Bush/Paulson/SIFMA.

The current situation has been over 15 years in the making.

Clinton may have set the stage. Bush hired the directors, instructed them to do nothing, then sat back as the players ran amock. This happned on Bush's anit-regulatory, government-is-bad watch.
Yes, why not just go back to Glass--Steagall?
It worked for 60 years.

The whole country needs to ratchet back our needs,
wants, and basic living to the ""adults of early 1960s levels.

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