This is the third post on the topic.  As promised, I will attempt to address whether the currently proposed regulatory overhaul can help mitigate against the risk of excessive risk-taking and speculative behavior.  That is, can the prevention of “too big to fail,” increased capital ratios among large banks, and the 2,315-pages of financial regulatory system legislation act as the “voice of reason” which will prevent future financial crises?

Well, a lot has happened since my past post:

• Central bank governors and regulators finalized a package that will recommend that banks more than triple the amount of top quality capital they must hold to withstand shocks without state aid (the so-called Basel III requirements);
• Six banks in the U.S. collapsed, bringing the total to 124 this year as the ramifications of the credit crises continued to take a toll (including one right here in West Allis, Wisconsin); and
• Gordon Gekko plans his return as the movie Wall Street: Money Never Sleeps premiers in theaters this Friday – I am sure that you will remember the speech from the first movie: 

The point is, ladies and gentleman, that greed, for lack of a better word, is good. Greed is right, greed works. Greed clarifies, cuts through, and captures the essence of the evolutionary spirit. Greed, in all of its forms; greed for life, for money, for love, knowledge has marked the upward surge of mankind. And greed, you mark my words, will not only save Teldar Paper, but that other malfunctioning corporation called the USA.  (http://www.youtube.com/watch?v=7upG01-XWbY)

First, we should discuss the new Basel III Accord and what that means in this new regulatory structure.  The Basel Committee  (the group responsible for the Basel Accords) consists of representatives of all of the G-20 countries (plus other important banking centers).  The Committee does not have the authority to enforce recommendations, although most member countries as well as some other countries tend to implement the Committee’s policies. This means that recommendations are enforced through national laws and regulations — so, while an important milestone, it throws us back to what is happening back here in the U.S.

President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law on July 21.  Among other things, the law will:

• Establish a new council of “systemic risk” regulators to monitor growing risks in the financial system, with the goal of preventing companies from becoming too big to fail and stopping asset bubbles from forming, such as the one that led to the housing crisis.
• Create a new Consumer Protection Bureau that is charged with writing and enforcing new rules that target abusive practices in businesses such as mortgage lending and credit-card issuance.
• Allow the government in extreme cases to seize and liquidate a failing financial company in a way that protects taxpayers from future bailouts.
• Give regulators new powers to oversee the giant derivatives market, increasing transparency by forcing most contracts to be traded through third-parties instead of only between banks and their customers.

The first prong of this, in my mind, is the most critical.  The new Financial Stability Oversight Council will have an incredibly broad and difficult mandate – essentially, its assignment is to monitor the entire financial landscape for risks that could spark another crisis, identify and supervise firms that could pose those systemic risks, and make sure they never grow so large, complex, and leveraged that their failure can wreak havoc across the globe.  In many ways, it is designed to play the role of the “voice of reason” that I discussed in my last blog.  The group will be led by the Treasury Secretary and will include the heads of the financial regulatory agencies. The 10 voting members include the heads of the Federal Reserve, the Federal Deposit Insurance Corp., and the Office of the Comptroller of the Currency. 

The Council will have the authority to direct regulators to issue new rules regarding capital, liquidity, and leverage levels and to impose more onerous rules on firms that it deems to be systemically important.  As a last resort, the Council can agree by a two-thirds vote to break up large, complex firms if members agree that they pose a grave threat to the country’s financial stability.  Finally, Council members will have at their fingertips another new entity, the Office of Financial Research, which will be staffed with economists, accountants, and other specialists to help collect and analyze real-time data, in hopes of identifying emerging threats to the financial system.

The creation of the Council reflects at least one important policy change.  The strengths of the Securities and Exchange Commission (SEC) are in the areas of disclosure and anti-fraud enforcement – but not as a financial regulator that imposes capital requirements or sets leverage restrictions.  [1]

So, can the new Financial Stability Oversight Council be more effective in this role and can it effectively play the role as the “voice of reason” that will prevent future crises?

Unfortunately, I believe that the answer is no.

I believe that there are 5 key reasons for this:

1. Washington, by its nature, is a reactive and not proactive type of decision-maker.  The creation of the Council was a political compromise and its decision-making structure (representation coming from many different agencies with different agendas) will not provide for an efficient and effective means of decision-making.  Greed, at the end of the day is a very difficult thing to regulate.  A council created by political compromise is not likely, in my mind, to be able to effectively control it.
2. Without the ability to influence monetary policy (i.e., interest rates) – a key ingredient in risk-taking and overall speculative behavior – the Council will be the tail wagging the dog.  A better approach, in my mind, would have been to give a single agency – the Fed – the mandate to do the Council’s job.
3. International competitive pressures will limit effectiveness.  Over the next decade (and remember that this new law will not be completely implemented until 2015, or later) some of the largest financial organizations in the world are likely to be outside of the U.S.  The largest banks will be in Asia or Latin America where the reach of the new legislative provisions will not apply.  This practical reality poses two problems:  (1) the Council will be under intense pressure to ensure that its requirements do not place U.S. institutions in an anticompetitive posture; and/or (2) due to the inter-connectedness of the world, the next financial crises may be caused by institutions in other regions.
4. Policy-makers and regulators will have great difficulty in keeping up with the pace of financial engineering.  Notwithstanding the creation of the Office of Financial Research, I have a very hard time in believing that this group will be able to keep pace with Wall Street.
5. The next crisis is likely to look much different than the one we just lived through (we may be prepared for the last one, but we are not likely to be prepared for the next one).

So, with all of that, I will stop for now.  But, I will leave you with a final reminder.  That is, if “Congress did not take away from the citizen his inalienable right to make a fool of himself” and simply “attempted to prevent others from making a fool of him” – please do not be foolish.

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[1] Some history here may be helpful.  Back in 2002 the European Union adopted a new regulatory regime referred to as the Financial Conglomerates Directive.  The main thrust of the E.U.’s new directive was to require regulatory supervision at the parent company of financial conglomerates that included a regulated financial institution (e.g., a broker-dealer, bank or insurance company). This new law potentially applied to U.S. investment banks because all did substantial business in the E.U. The E.U. directive contained an exemption for foreign financial conglomerates that were regulated by their home countries in a way that was deemed “equivalent” to that envisioned by the directive and the large U.S. investment banks lobbied the SEC aggressively to take action.   The SEC thus adopted the Consolidated Supervised Entity Program (CSE).  Firms that entered the CSE program were permitted to adopt more relaxed net capital rules governing their debt to net capital ratios. An irony in all of this is that the SEC believed that it is was adopting more modern, advanced standards utilized by the Federal Reserve Bank under the Basel II Accord.  In 2004 this program was adopted – the practical consequence was that the SEC relaxed the leverage ratio for investment banks from $12 to over $30 for each $1 of capital.  Yes, you can now think about the failures of the large investment banks that fully utilized these newfound leverage abilities (think Bear Stearns, Merrill Lynch, and Lehman Brothers).  During this period, the market for repurchase (“repo”) agreements – the major source of funding for leveraged positions – rose from $788 billion in 2001 to $2.3 trillion in 2007. Just before the crash, most of these financial institutions had maxed out their debt-to-capital ratios to 30-to-1, and the ratio was much higher for those with extensive off-balance-sheet positions.