Friday, May 21, 2010

Financial Reform Provisions: what concerns me, what I like, what I wish they'd add, and a general takeaway

4 things that concern me:
"Most controversially, the bill would adopt language written by Sen. Blanche Lincoln (D., Ark.), that would compel any large commercial banks that have access to the Federal Reserve's discount window to spin off their derivatives trading business. The Fed, FDIC, Treasury as well as the banking industry have argued against this measure."

This is EXTREMELY stupid, and would actually increase the risk of the financial industry. There are two major reasons:
1) The minor point is that the more sources of revenue a bank has, the less likely it is to fail if one of them goes sour.
2) More importantly, a major reason for commercial banks to have derivatives trading desks is so that they can hedge their own risk away through fixed-for-floating interest rate swaps and credit default swaps. Not letting them hedge may make their risk easier to measure, but it also makes it higher. As Buffett says, it's better to be approximately right than to be precisely wrong. This measure will increase the risk banks face, not decrease it, and just because we're able to see collapses coming doesn't make it easier to unwind those exposures. EDIT: I may have misread this. As long as commercial banks are still allowed to OWN rate swaps and CDS, then not writing them is more ok. You still have the "diversified revenue streams are good" factor, but this is FAR less negative and I could even see it defended as a positive.
EDIT 2: According to this, my initial concerns are very legitimate:

"Calls for a one-time government audit of the all of the Fed's emergency lending programs from Dec. 2007 onward, including facilities used to help deal with the collapse of Bear Stearns & Co. and the program to stabilize asset-backed securities markets. The Government Accountability Office would also review the Fed's corporate governance, including whether there are conflicts of interest inherent in the current design of the Federal Reserve System."

The GAO has more conflicts of interest than the Fed does. One of the reasons the Fed has been so effective for the last 60 years is that it is independent, and is NOT accountable to Congress - if it feels raising interest rates are appropriate, then it raises them. If this move gets the Fed constantly looking over its shoulder when it moves to make sure it's not going to get in trouble with Congress, that will severly undermine its efficacy. It's hard to know if this problem will be exacerbated by the myriad of new powers granted to the Fed.

"Under an amendment adopted unanimously with little fan fare, the bill would force banks with more than $250 billion in assets to meet higher risk- and size-based capital standards. Treasury and Fed oppose the measure, authored by Sen. Susan Collins (R., Maine), warning it could make it harder for U.S. officials to negotiate global capital standards with foreign regulators."

Too Big to Fail is not the issue, and I'm interested to see if this would distort the incentives of banks hovering right around $250 billion in assets - would customers be treated worse? I don't know why Treasury and Fed say it'll be harder to negotiate global capital standards, but it is plausible, and if I had to take either Treasury and Fed's word for it or Congress's, I'll go with Treasury and Fed every single time.

"Would create a new Consumer Financial Protection Bureau within the Federal Reserve, with rulemaking and some enforcement power over banks and non-banks that offer consumer financial products or services such as credit cards, mortgages and other loans. "

The issue here is not what it is in the bill, but what it will evolve into. These bureaucracies never stay stable and never become efficient, and I worry that it will end up intervening in places it doesn't understand and make things worse, not better, either by stunting growth or permitting (or even forcing) risk.

4 things that I (think I) like:

"Would give shareholders of public corporations a non-binding vote on executive pay, and would give the SEC the authority to grant shareholders proxy access to nominate directors."

About time. I just wish they'd kill off proxy voting entirely.

"Would require the vast majority of all derivatives trading be executed on a public exchange as opposed to between banks and their customers as many contracts are currently."

Everyone likes to think that this is a panacea. It's not, but it's not a bad step.

"Sets up a liquidation procedure run by the FDIC."

Some stability in liquidation rules would be very, very helpful, so that we can look and understand exactly what will happen. This, of course, assumes the liquidation procedure is intelligent, but we don't know how it's going to work yet. I'll give the FDIC the benefit of the doubt.

"Would require firms that securitize mortgages and other loans to hold a portion of the risk on their own balance sheets."

This was the fundamental flaw in the Basel II capital accords that facilitated a lot of these problems in the first place - banks did that already, then everyone decided they needed more regulation and banks all of a sudden couldn't really do that as easily anymore, and everything turned downhill. The best part of this is that it also applies to the mortgage brokers, who are different to the banks and far more seedy (they're the 'predatory lenders' ripped apart in the news).

-"Living Wills" and each bank funding their own bailouts (which is the same as tighter capital requirements except psychologically different in the management of the firm)
-Contingent-convertible debt
-More limitations on high-frequency trading
-More on flash trading and dark pools (flash trading is blatantly unethical, and dark pools are only super important because of flash trading)
-An accelerating bailout tax - so that people understand exactly how they'll suffer if they'll bailed out.
-Reform/relaxation of Mark-To-Market rules
-Fewer subsidized mortgages

General Takeaway:

This still seems to me like the impressive observation of one of the New York Times columnists a few weeks ago - "This bill seems to feel that since the establishment (banks, regulators and government) couldn't predict the last bubble, more power should be vested in them to predict the next one." Fundamentally, I don't know that we've reduced risk by that much. I see a number of unintended side effects, a few good things, and generally just a very blah bill. It's not downright economically destructive the way the healthcare bill is (though I am concerned about the Fed audit and not allowing commercial banks to hedge rates and defaults)... it just seems uninspiring. 

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