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All that talk about tighter regulation [ClearOnMoney]
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All that talk about tighter regulation

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Commentary

All that talk about tighter regulation

20 Apr 2010 by Jim Fickett.

There is much discussion about regulatory reform, in order to prevent future financial crises. As a voter, I do follow the debate, but as an investor I think the regulatory rules are nearly irrelevant for understanding future crises. The reason? Regulators don't do their jobs. Financial crises are a permanent fixture, and investors should plan accordingly.

This is not a systematic piece; rather a loose collection of glaring examples to make the case clear.

Severe conflict of interest is tolerated in high office

Larry Summers, Director of the White House's National Economic Council, has earned millions of dollars from the financial industry in consulting and speaking fees.

When AIG was bailed out, they were encouraged to pay out in full on credit default swaps to the banks, most prominently Goldman Sachs. There has been considerable controversy about this action since – it was probably an unnecessary transfer of wealth from the taxpayers to the banks. When the AIG crisis broke, the only Wall Street representative asked to confer with Henry Paulson, himself formerly of GS, was Lloyd Blankfein of GS. At the time, Edward Libby, who had been asked by Paulson to take on the role of CEO at AIG, owned more than $3 million in GS stock.

Stephen Friedman held Goldman stock, and bought more, at the same time that he was board chairman for the Federal Reserve Bank of New York, with supervisory responsibility for Goldman.

The House Committee on Financial Services is the second largest in Congress, partly because an appointment there is widely regarded as a key to fundraising. Many members of the committee raise a large fraction of their campaign funds from the financial sector. Members of the committee were trading bank stocks during the approval of government bailout programs.

Willem Buiter, currently a member of the Asian Development Bank's International Monetary Advisory Group, a research associate at Australian National University, a member of the Supervisory Board for Robeco Groep, associate editor for the Journal of Financial Economic Policy, a senior research associate at the London School of Economics and Political Science, and Chief Economist at Citibank, (in other words, not some fly-by-night conspiracy theorist)wrote last year in his blog at the Financial Times:

I used to believe this state [regulatory] capture took the form of cognitive capture, rather than financial capture. I still believe this to be the case for many, perhaps even most of the policy makers and officials involved, but it is becoming increasingly hard to deny the possibility that the extraordinary reluctance of our governments to force the unsecured creditors (and any remaining non-government shareholders) of the zombie banks to absorb the losses made by these banks, may be due to rather more primal forms of state capture.

Regulators who try to do their job often find it impossible

Brooksley Born, a top securities lawyer who was appointed to head the Commodity Futures Trading Commission in 1996, foresaw much of the disastrous effect of an unregulated derivatives market. When she tried to put meaningful regulation in place, Alan Greenspan, Robert Rubin, and Larry Summers went over her head to Congress and stopped her.

It has been quite common for bank examiners from the Office of Thrift Supervision or from the FDIC to uncover serious problems at a bank and write them up, but for their bosses in Washington to choose to do nothing, and even to ridicule the examiner.

There is a good description of the dynamic at Interfluidity. In short, during the boom times anyone who warns about problems looks silly, especially if, as usual, the problems go on for a long time before coming to a head.

The SEC took no action even when the case was clear

On Wall Street, it was an open secret that Madoff was a fraud, because no one could find any evidence that he did any trading. But despite numerous credible complaints, and several investigations, the SEC never independently verified Madoff's assertions and, in particular, never checked to see whether he did any trading.

The SEC investigated Allen Stanford four times, beginning in 1997, and concluded internally that his operations were likely fraudulent, but did nothing.

Anton Valukas, author of the much-publicized 2209-page report on the Lehman bankruptcy, recently testified to Congress,

the SEC was aware of these excesses and simply acquiesced …

the agencies were concerned. They gathered information. They monitored. But no agency regulated. …

What is clear is that the regulators were not fully engaged and did not direct Lehman to alter the conduct we know in retrospect led Lehman to ruin. Someone must be in charge. And the agency in charge must have the will to act.

The Federal Reserve has been oblivious to systemic problems

From 1998 to 2007 consumer advocates, state governments, the GAO, HUD, and others pointed out the lax lending standards in the mortgage market to the Fed, and asked them to look into the subprime affiliates of the major banks. The Fed consistently resisted, until in the summer of 2007 it announced it would begin to look into the issue. By then it was too late.

In the fall of 2006 the Fed reviewed the largest banks and found "no substantial issues of supervisory concern". This was well into the age of CDOs and option ARMs.

One major contributor to the crisis was that bankers were often rewarded with large bonuses for profits that turned out later to be illusory. When the G20 leaders discussed this problem it was generally agreed to work towards an internationally-agreed rule delaying, for example, 40-60% of the bonus payment for 3-5 years. The Fed strongly resisted this idea.

Joseph Stiglitz, former chief economist at the World Bank, spoke the unspeakable, saying that

if a country had applied for World Bank aid during his tenure, with a financial regulatory system similar to the Federal Reserve's – in which regional Feds are partly governed by the very banks they're supposed to police – it would have raised alarms.

“If we had seen a governance structure that corresponds to our Federal Reserve system, we would have been yelling and screaming and saying that country does not deserve any assistance, this is a corrupt governing structure,” Stiglitz said during a conference on financial reform in New York. “It's time for us to reflect on our own structure today, and to say there are parts that can be improved.”

In summary

The government stopped the immediate crisis by taking upon itself the systemic risk. But there has been no real change in the system that gave rise to the crisis.

I'll leave the final word to Martin Wolf, chief economics commentator at the Financial Times:

In a speech last week, [Larry Summers] noted that “roughly every three years for the last generation a financial system that was intended to manage, distribute, and control risk has, in fact, been the source of risk – with devastating consequences for workers, consumers, and taxpayers.” …

Trying to make financial systems safer has made them more perilous. Today, as a result, neither market discipline nor regulation is effective. There is a danger, therefore, that this rescue will lead to still greater risk-taking and an even worse crisis at some point in the not too distant future.