Geithner Talks Up Regulation . . . Will It Happen, and Would That Be a Good Thing?

Tim Geithner said yesterday that the banking crisis shows that the U.S. financial system failed a major test and is in need of a regulatory overhaul.

Geithner said that the Obama administration wants to put in place a stronger, more stable system with a modernized government regulatory structure: ” Our system basically failed its most fundamental test. It was too fragile.”

As AFP writes:

“To make the system more stable in the future, to end this cycle of boom/bust, major financial crises every five years or so,” the Treasury chief told the CNBC network.

To that end, he said, there will be “better resolution authority” to unwind collapsed firms such as AIG and Lehman Brothers, and curbs on executive compensation after a furor over lavish bonuses paid out by AIG….

Obama says more permanent changes are needed such as a “systemic risk regulator” to sound the alarm before a collapse becomes imminent.

Officials say the government also needs new powers similar to the authority enjoyed by a bankruptcy judge to restructure a failed company, to cover not just banks but major non-bank financial institutions such as hedge funds.

And exotic investment tools that long operated under the radar, such as the “credit default swaps” blamed for AIG’s demise, are expected to be brought onto open exchanges….

In an unusual joint statement Monday, the Treasury and Federal Reserve pledged to work with Congress “to develop a regime that will allow the US government to address effectively at an early stage the potential failure of any systemically critical financial institution.”

Is this new push to regulate for real? And will it be helpful?

Will the Foxes Let New Guards Into the Chicken Coop?

Will regulation actually occur?

Well, the most powerful player in Obama’s economic team – Larry Summers – is one of the three or four people most responsible for the deregulation in the first place. As a 1999 New York Times article entitled “Congress Passes Wide-Ranging Bill Easing Bank Laws” quotes Summers as saying:

”Today Congress voted to update the rules that have governed financial services since the Great Depression and replace them with a system for the 21st century,” Treasury Secretary Lawrence H. Summers said. ”This historic legislation will better enable American companies to compete in the new economy.”

The Times’ article also quotes prophetic critics of the deregulation:

The opponents of the measure gloomily predicted that by unshackling banks and enabling them to move more freely into new kinds of financial activities, the new law could lead to an economic crisis down the road when the marketplace is no longer growing briskly.

”I think we will look back in 10 years’ time and say we should not have done this but we did because we forgot the lessons of the past, and that that which is true in the 1930’s is true in 2010,” said Senator Byron L. Dorgan, Democrat of North Dakota. ”I wasn’t around during the 1930’s or the debate over Glass-Steagall. But I was here in the early 1980’s when it was decided to allow the expansion of savings and loans. We have now decided in the name of modernization to forget the lessons of the past, of safety and of soundness.”

Senator Paul Wellstone, Democrat of Minnesota, said that Congress had ”seemed determined to unlearn the lessons from our past mistakes.”

”Scores of banks failed in the Great Depression as a result of unsound banking practices, and their failure only deepened the crisis,” Mr. Wellstone said. ”Glass-Steagall was intended to protect our financial system by insulating commercial banking from other forms of risk. It was one of several stabilizers designed to keep a similar tragedy from recurring. Now Congress is about to repeal that economic stabilizer without putting any comparable safeguard in its place.”

Will Summers – the most powerful economics player in the Obama administration – let any real regulation occur?

Will Geithner – the guy who let the banks run amok when he was head of the New York Fed, and who is adopting the banks’ own fuzzy math in assessing their health today – really push for change?

I would like to hope so, but their track record doesn’t make it seem likely.

If Regulation Is Enacted . . .

I agree that the system is in need of a regulatory overhaul.

The feds already have the authority to unwind collapsed companies. But I agree that more authority to unwind collapsed giants would be helpful, if for no other reason then that it might give more backbone to regulators to do so (by providing political cover in the form of explicit laws saying they can).

The Fed has been the bubble-blower-in-chief for decades. The Fed is a large part of the problem, and should be disbanded or brought under Federal control. In any event, don’t give the Fed more powers to oversee and “stabilize” the economy. The Fed has proven for almost 100 years that it will botch the job.

And putting CDS on exchanges is not enough, and does not address the fundamental problems. Nobel economist Myron Scholes has slammed the business-as-usual approach of the Obama administration to credit default swaps:

The “solution is really to blow up or burn the OTC market, the CDSs and swaps and structured products, and let us start over,” he said, referring to credit-default swaps and other complex securities that are traded off exchanges. “One way to do that, through the auspices of regulators or the banking commissioners, is to try to close all contracts at mid-market prices.”

By “close all contracts at mid-market prices”, I think Scholes means reform the CDS contracts by insisting that counterparties take a haircut, insisting that the counterparties not get full value for the contracts, and that the CDS contracts be paid out and done with. That’s what I’ve been pushing for months (see this, for example).

Finally, regulation should address the core issues that got us into this mess, including:

  • Reigning in fractional reserve lending
  • Reigning in leverage
  • Re-enacting Glass-Steagall
  • Reigning in all credit derivatives, including CDS
  • Reigning in any future financial instrument or scheme – no matter what it is called – which creates too much leverage
  • Making all financial institutions keep accurate books, and repealing all laws which give them wiggle room to cook their books
  • Preventing any company from becoming too big to fail
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