Posted on the Baseline Scenario by Simon Johnson:
Writing in the Washington Post this morning, Tim Geithner and Larry Summers outline a five point plan for dealing with the underlying problems in our financial system, entitled A New Financial Foundation.
The authors are not completely clear on what they think caused the current crisis, but you can back out some points from their reasoning – and the implicit view seems quite at odds with reality.
- Their view: Regulation is overly focused on safety and soundness of individual banks. Reality: There was a complete failure of safety and soundness supervision. This must be fundamental to any financial system – without this, you’ll get mush every time.
- Their view: “A few large institutions can put the entire system at risk,” so we need a system regulator. Reality: you need to control the behavior of large institutions, more than a few of which got us into this mess. If you can’t come up with a proposal to prevent them from taking system-damaging risk (and there is nothing in today’s article about this), then break them up. The article mentions penalties for being large - higher capital and liquidity requirements for larger banks; we’ll see the details in/after Geithner’s speech tomorrow, but I am not holding my breath for anything meaningful.
- Their view: All large firms will be subject to consolidated supervision by the Federal Reserve and there will be a council of supervisors. Reality: we have plenty of layers, up to “tertiary” regulators (and beyond, in some senses) and there is already enough opportunity for regulatory arbitrage. What prevents the biggest banks from capturing or manipulating regulators? There is no mention in today’s document of the extent to which everyone, including the authors, believed in the big banks’ risk management abilities last time – and continue to rely on the advice of their people today.
- Their view: The originator “of a securitization” will be required to “retain a financial interest in its performance.” Reality: It was a big unpleasant shock when everyone realized that Lehman, Bear Stearns, and others had retained a large exposure to dubious financial products, some of which they had issued. We are back to the Greenspan fallacy here – if financial firms have an incentive not to screw up on a massive scale, they won’t.
- Their view: “[T]he administration will offer a stronger framework for consumer and investor protection across the board.” This sounds incredibly vague and may be the worst news today. It looks like they are backing away from the idea of a Financial Products Safety Commission, for example as proposed by Elizabeth Warren.
And of course the complete omissions from this document are breathtaking. No mention of executive compensation or the structure of compenstion within the financial sector. Not even a hint that the complete breakdown of corporate governance at major banks contributed to execessive risk taking. And no notion of regulatory capture-by-crazy-ideas of any kind.
There are a couple of positive notes towards the end. The administration will seek a resolution authority for dealing with failed banks, but we knew this already. And the authors recognize the need to change how financial systems operate around the world; unfortunately, there is zero detail on this crucial point.
Overall, there are no surprises here. Brick by brick, we are building the foundation for the next financial crisis; by all indications, it will be more disruptive and a great deal more damaging than the crisis of 2008-09. But presumably by then the authors will be out of office.