Half measures

EVER since President Barack Obama assumed office, he has been preoccupied with efforts to resolve the financial collapse and reverse the economic downturn that the United States has been experiencing for a year and a half now. But the big economic policy thrust everyone was awaiting was his administrations medium- and long-term response to the crisis in the form of a financial re-regulation package that would seek to prevent the recurrence of crises of this kind. The consequences of the savings and loans crisis, the dotcom bust and the financial manipulations at Enron and WorldCom (among others) were bad enough, but the financial collapse triggered by the sub-prime crisis was too close to the collapse of the 1930s to brook further delay in rethinking the deregulation that is now widely seen as having contributed to these developments. A Roosevelt moment had come, and it needed a response that in significance equalled the framework epitomised by the Glass-Steagall Act of 1933.

The Obama administration announced the much-awaited package on June 17, led by a statement by the President. But implicit in that statement were indications of the compromises that the regulatory package would include compromises that could make it inadequate to the task it seeks to address. While admitting that the economic downturn was a result of an unravelling of major financial institutions and the lack of adequate regulatory structures to prevent abuse and excess, Obama did not blame the dismantling of the regulatory regime that was put in place in the years after 1933 for these developments. He attributed them to the fact that a regulatory regime basically crafted in the wake of a 20th century economic crisis the Great Depression was overwhelmed by the speed, scope and sophistication of a 21st century global economy. Glass-Steagall was not the model for re-regulation but the outdated other, which needed to be substituted with a new regime. What mattered was not the dismantling of the structural regulation that Glass-Steagall epitomised but the vestiges of that framework that remained.

Despite this important compromise, the new package incorporates a number of important regulatory advances. To start with, recognising that there are in the current financial scenario a number of institutions banks and non-banks that are too big to fail, because their failure can have systemic effects, the package gives the Federal Reserve a new role in overseeing and regulating these entities. This implies that institutions other than banks, which constitute the shadow banking sector that both mobilised investments and borrowed many multiples of that to finance its activities, will come under Fed scrutiny and influence. It is unclear what the criteria for identifying these too big to fail entities will be, but once identified they will be regulated with the intent of pre-empting fragility.

It hardly bears emphasising that these entities are not just large in size but are diversified as well because the walls between different segments of the financial sector (conventional banking, investment banking, insurance, and so on) were completely dismantled by 1999. To assist the Fed in monitoring and regulating these diversified firms, the administration plans to establish a Financial Services Oversight Council, which will bring together regulators from across markets to coordinate and share information; to identify gaps in regulation; and to tackle issues that dont fit neatly in an organisational chart.

Moreover, these entities would be subject to more stringent regulations with regard to capital adequacy and liquidity. Note, however, that the effort here is not to limit size to prevent the emergence of institutions that are too big to fail, as has been suggested by some, but to attempt to prevent failure of large firms.

Since it is impossible to guarantee that this will work at all times, the package promises to devise a system that would allow firms to be unwound without damage to the system and excessive burdens on the taxpayer. The proposed resolution authority would work out a set of orderly procedures for breaking up or liquidating large and interconnected financial firms without overly damaging the economy.

A second major lesson from the crisis was that a deregulated system that allows for securitisation and the transfer of risk significantly discounts risk when credit assets are first originated. This is inevitable since the originator does not herself carry that risk after transfer. In addition, experience shows that securitisation aimed at transferring credit risk and deriving revenues from fee and commission incomes also leads to the sequential creation of composite derivative assets whose complexity precludes proper assessment of risk.

This experience led to suggestions that such opaque instruments should be banned and, more transparent, simple and standardised instruments that are traded in exchanges should be the norm. This is a suggestion that the Obama administration has largely sidestepped, though it wants to limit over-the-counter transactions. According to Treasury Secretary Tim Geithners statement to the Senate Banking Committee, the new package is based on the belief that you cannot build a system based on banning individual products because the risks will simply emerge in new forms. So the focus is on making instruments more transparent as well as changing the incentive structure by getting firms to hold a minimum material interest in the instruments they create. Their own exposure is expected to limit risk.

However, there is no clear indication who is to be assessed for riskiness and how. Nor is there clarity on whether and how institutions such as the rating agencies, which failed miserably when assessing risks, would be made to function better.

The result of this liberal approach is that controls on the kind of financial products the system can generate would be restricted to areas where they directly affect the retail consumer. A new institution the Consumer Financial Protection Agency will have powers to regulate any institution that provides financial products or services to retail consumers, whether they be banking or non-bank entities. This would, for example, clamp down on the kind of risky and complex mortgages offered by mortgage brokers, the implications of which were not often fully understood by borrowers.

Having decided not to go in for structural regulation, the new package talks of new guidelines with respect to capital requirements (adequacy) and prudential norms, which are expected to reduce the degree of leverage in the system, raise the cost of credit and possibly affect profitability. According to an administration official quoted by Financial Times, the new guidelines will be aimed at delivering more, better and less pro-cyclical capital.

While these are the core elements included in the new package, there are many features that were expected to be dealt with but have been missed out. There are two in particular that stand out. One is the unwillingness to substantially reduce the multiple agencies at the national and State levels, with overlapping jurisdictions, that currently define the regulatory framework in the U.S. Expectations were that the re-regulation would deliver a leaner framework with less agencies that have stronger and well-defined powers and clear-cut jurisdictions of their own. In the effort not to rock the boat by treading on powerful interests, the current reform package dumps just one agency, the Office of Thrift Supervision, and balances that with the new consumer protection agency.

Multiple regulators work reasonably well in a world where segments of the financial system are separated. That has changed over the past three decades, and there is no intent here to return to the past. In the event, multiple regulators encourage efforts at regulatory arbitrage, with institutions seeking the least obtrusive regulator to register with. It is unclear how the current reform would deal with this issue.

A second area that the new package leaves untouched is the much discussed and highly controversial area of executive compensation in the financial sector. The issue is not just that some executives were being paid unjustifiably high salaries and bonuses even in companies that were not that successful.

The real problem was that the compensation system incentivised risky behaviour and encouraged speculative investments. In the process, it was not talent or experience that was being rewarded but the ability to exploit legal loopholes to expand the business even at the cost of courting excessive risk. Expectations were that this would be curbed, but there appears to be no mention of regulation in this area.

Thus, at the centre of the new financial framework are a set of unchanged beliefs on how financial markets function and therefore should be regulated. The first is that if norms with regard to accounting standards and disclosure were adhered to, capital provisioning, in the form of a capital adequacy ratio, is an adequate means of insuring against financial failure. The second is that financial innovation should be encouraged. In the words of Geithner, The United States is the worlds most vibrant and flexible economy, in large measure because our financial markets and our institutions create a continuous flow of new products, services and capital. That makes it easier to turn a new idea into the next big company. The third is that this whole system can be partly secured by allowing the market to generate instruments that helped, spread, insure or hedge against risks. These included derivatives of various kinds.

By sticking to these beliefs, the Obama administration has ensured that it does not return to the structural regulation that Glass-Steagall epitomised but continues with the more liberal regime that was fashioned in the years since the late 1970s. Unfortunately, those were also the years when bank closures, bankruptcies and financial crises increased in number, scale and scope.

This is indeed unfortunate because the significance of the Obama package rests not only in its likely impact on the worlds leading financial firms that operate out of the U.S. but also in the fact that the U.S. provides the model for financial systems elsewhere in this globalised world. If implemented in the U.S., the Obama administrations blueprint for 21st Century Financial Regulatory Reform could serve as the road map for other developed and developing countries as well.

Past experience suggests that the problem here is not just that Obama has not gone far enough. He has left the system vulnerable to crises of the kind that it is even now battling.