Financial Reform

Since the document laying out the President's financial reform package is 88 pages, I will concentrate my evaluation on a few basic issues. 1) Do the reforms rely mainly on regulatory discretion or on new rules? 2) Is there adequate attention to the issues raised by financial institutions being "too big to fail"? 3) Is it proposed to micromanage the operations of financial institutions and individuals? 4) Most important, are these reforms likely to greatly reduce the likelihood of another financial meltdown? I take them up in turn, but my overall grade for the plan is no higher than a B-, and perhaps as low as a C. During this crisis, regulators of banks and other financial institutions generally did not use the authority they already had to rein in the asset expansion and various excesses of commercial banks and other financial institutions. This is not at all surprising since regulators usually get caught up in the same "exuberance" as bankers, and no more see the looming risks to the system and to individual banks than do bank executives. Moreover, examples from many industries show that regulators frequently get "captured" by regulated firms, and tend to support the interests of these firms. This occurs even when the actions of firms are contrary to the public interests, and when regulated firms do not bribe or exercise other improper influence on regulators. For these reasons, any new regulations should mainly operate automatically through rules rather than relying on discretionary decisions of regulators. Unfortunately, although the plan does contain new rules, they rely too much on discretionary choices of regulators. For example, the plan advocates creating a mechanism that allows regulators to take over large, failing financial firms, and to decide how to fix them, but it does not specify how the regulators should fix banks, or even when they should take them over. The plan encourages the Fed to monitor systemic financial risk, but it does not indicate how the Fed should determine whether systemic risks are excessive. My overall grade on the place of rules vs. discretion in the proposed changes would be no higher than a B-. Countries tend to bailout large firms more often they should, including large and/or highly interrelated banks and other financial institutions. Nevertheless, big and complex financial institutions that appear to be failing will often be bailed out in the future, especially in light of the perception that the failure of Lehman Brothers triggered a sharp worsening of the crisis, and a dramatic retreat from risk. In order to reduce the likelihood of the need for such bailouts, large banks should be required to have especially high capital requirements (see my post on March 9). Perhaps they should also be forced to have much of their capital in liquid forms. The President does propose that the Fed should more heavily regulate and supervise large financial firms- possibly including special capital requirements- but the proposals appear to give the Fed much more discretion than is desirable. Overall, the grade on the too big to fail proposals is a B or B+. Abundant evidence from the US experience and that of other countries indicates that governments do badly when they attempt to micromanage firms and individuals in the financial and other sectors. Nevertheless, the government proposes to have regulators issue guidelines on executive pay, with the intent of "better" aligning pay with stockholder value. It also wants to "better" relate the compensation of financial firms to the long-term performance of their loans, and to require non-binding shareholder votes on executive compensation. Another proposal would prevent "unsophisticated" individuals from trading derivatives "inappropriately". Others would ban or restrict mandatory arbitration clauses, and would regulate bank overdraft provisions. Still other parts of the plan would mandate that some employers offer automatic IRA plans to employees, and the government proposes to regulate closely the investment choices made by holders of these plans. The degree of micromanagement of company and individual behavior in these and other provisions is distressingly high (see our posts on the case against controls over executive pay on June 14th). This is why the overall grade on the proposed degree of micromanagement of financial institutions and individual behavior is no higher than a C. Would the changes embodied in President Obama's financial plan greatly reduce the likelihood of another major financial crisis? An honest answer is that no one really knows because it is not yet clear which of the myriad aspects of the American financial system were the most important causes of the crisis. For example, some discussions blame the generous compensation packages provided to executives of banks and funds, especially the close dependence of total executive compensation on current profits and the value of their stock holdings. However, Japan had a terrible financial and economy wide crisis throughout the 1990s, even though Japanese executives are paid much less than their American counterparts, and Japanese executive pay is much less dependent on profits and stock prices. Others have claimed consumer ignorance is responsible for the sharp growth in subprime and other mortgages, and for the great expansion of credit card debt. Yet who could blame poorer families for buying homes when they received great deals in the form of low interest rates-partly due to the Fed's policies! - and very low down payment requirements. Low down payments and low interest rates might have been mistakes of the lenders, and of government policy that encouraged such loans, but they hardly indicate that consumers were fooled into taking out these mortgage loans. Similarly, lower income consumers like to borrow on their credit cards because that debt is often the cheapest and most flexible form of credit available to them. Small print on credit card contracts and fast-talking mortgage salesmen were just not important forces in determining what happened in mortgage and other consumer credit markets. A basic problem is that when little is known about the likely effects of new financial regulations, they are more likely to harm rather than help the financial system. Suppose, for example, that regulation of pay of financial executives appears to have a 1/2 chance of improving the efficiency of the financial sector by 25%, and a 1/2 chance of reducing efficiency by the same 25%. The average expected impact of such pay regulation on efficiency would be zero, but it would increase risk by raising the expected variance in the efficiency of outcomes. Therefore, when there is sizable ignorance about the consequences of new regulations, governments should only introduce those financial reforms that are much more likely to improve rather than worsen the performance of the financial sector. When the government's financial proposals are evaluated from the medical principle of "do no harm", they cannot be given better than a C grade. The lesson from this low grade is not to stop reforming the financial sector, but to go slowly, and introduce now only those changes that seem quite likely to reduce the prospects of another crisis. For example, higher capital requirements, especially for larger banks, seem to be justified even though the precise role in the crisis of high and growing leverage of bank assets is not clear. Similarly, central counterparty exchanges for derivatives are often desirable, although the benefits are likely to be greater if traders are induced to participate in these exchanges rather than mandated to do so. The case for other changes in financial markets may also be strong. However, most of the proposals in the President's plan should be put on hold until much more is learned about the causes and possible cures for this and future financial crises.