Sunday, May 23, 2010

Financial market regulation proposals update

Mike Konczal has an excellent summary of all the various financial market regulation proposals under discussion in the US. They include the House and Senate versions of the Financial Market Regulation Bill and President Obama's White Paper. The graphics below compares each of the three proposals with a "healthy markets" proposal with respect to

1. Consumer financial protection (independence Vs transparency)

2. Derivatives and shadow banking sector reform (levels of systemic risk Vs transparency)

3. Creation of a resolution authority (detection Vs deterrence)

4. Overall assessment of the pro and cons of the three proposals (levels of regulation Vs transparency)

About the resolution authority, the newest dimension to the debate comes in the form of "living wills" from Alan Greenspan's elaborate explanation fo the sub-prime crisis cum defense of his actions as Fed Chairman. He has proposed "living wills" for all financial intermediaries where they publicly disclose (thereby pre-empt counterparties from complaining after the fact that they thought they had more legal rights in the event of liquidation than they do) their own plans to wind down in the event that they fail, thereby leaving policymakers with a a game plan in hand if these instiutions fail.

This would essentially mean, as Economics of Contempt writes, "Instead of providing a plan for the financial institution's own resolution, we should instead use living wills as a way to force financial institutions to provide regulators with all of the information they'd need to actually carry out a rapid and orderly resolution." However, as it writes, relying on the financial institution to submit a plan for their own resolution may not be a good idea, especially given the moral hazard generated by the recent experiences.

In an excellent post, Mark Thoma makes the point that while reducing the size of banks is important from a political economy perspective, and also from a market power perspective, we will also need to have leverage limits, limits on connectedness, limits on the concentration of risks, etc. He argues that while it may be impossible to guarantee against another financial bubble blowing up, these restrictions can make it harder for bubbles to inflate.

Taking forward Mark Thoma's arguement, the utility of such restrictions may not be so much in eliminating bubbles (which will continue to get inflated nevertheless), but as in minimizing the damage due to these bubbles and in making it easier to clean up afer the bubbles bursts.

See also Steve Waldman who writes, "totemic leverage restrictions will not meaningfully constrain bank behavior. Bank capital cannot be measured... 'Large complex financial institutions' report leverage ratios and 'tier one' capital and all kinds of aromatic stuff. But those numbers are meaningless. For any large complex financial institution levered at the House-proposed limit of 15X, a reasonable confidence interval surrounding its estimate of bank capital would be greater than 100% of the reported value. In English, we cannot distinguish 'well capitalized' from insolvent banks, even in good times, and regardless of their formal statements."

See also this debate on the Dodd Bill currently under discussion in the US Senate. Simon Johnson feels that the Bill misses a huge piece without any provision for a cap on size. Mark Thoma agrees with Simon Johnson, but argues that small banks with inter-connected risks could pose just the same problem. He also proposes leverage restrictions, at say 15:1.

Two days back, the US Senate finally passed its version of financial reform bill, sponsored primarily by Senator Christopher J. Dodd. It would seek to curb abusive lending by creating a powerful Bureau of Consumer Protection within the Federal Reserve to oversee nearly all consumer financial products; to ensure that troubled companies, no matter how big or complex, can be liquidated at no cost to taxpayers; empower regulators to seize failing companies, break them apart and sell off the assets, potentially wiping out shareholders and creditors. It would also create a “financial stability oversight council” (composed of the Treasury secretary, the chairman of the Federal Reserve, the comptroller of the currency, the director of the new consumer financial protection bureau, the heads of the Securities and Exchange Commission and the Federal Deposit Insurance Corporation, the director of the Federal Housing Finance Agency and an independent appointee of the president) to coordinate efforts to identify risks to the financial system; establish new rules on the trading of derivatives and require hedge funds and most other private equity companies to register for regulation with the Securities and Exchange Commission; and force big banks to spin off some of their most lucrative derivatives business into separate subsidiaries.

The Bill also seeks to impose a thicket of rules for the trading of derivatives, and with limited exceptions, derivatives would have to be traded on a public exchange and cleared through a third party. Further, some of the biggest banks would be forced to spin off their trading in swaps, the most lucrative part of the derivatives business, into separate subsidiaries, or be denied access to the Fed’s emergency lending window. Features of the Senate Bill and a comparison with the House Bill are available here and here.

Update 1 (30/5/2010)
Economist has this comparison of the Senate and House versions of financial market regulation proposals.

Update 2 (1/6/2010)
Michael Lewis has this superb parody op-ed on financial market regulation proposals and what Wall Street should be doing to defeat them.

Update 3 (26/6/2010)

The US financial market regulation proposals come one step closer to adoption, as the members of the House-Senate committee arrived a mutually agreeable set of proposals from their respective bills. They include restrictions on trading by banks for their own benefit and requiring banks and their parent companies to segregate much of their derivatives activities into a separately capitalized subsidiary.

On the Volcker Rule which limits banks in making their own investments or putting money in hedge funds, the compromise proposals would bar banks from some kinds of speculative investing, but still can invest up to 3% of their equity in hedge funds and private equity funds. See this, this, and this on the bills.

Edmund Andrews has a nice summary of the proposals - The bill would give the government new power to oversee systemic risk and to shut down giant failing institutions (another AIG) in an orderly way. It includes a surprisingly strong “Volcker Rule,’’ which almost prohibits banks, with their federally-insured deposits and special access to Fed borrowing, from engaging in proprietary trading. It sharply restricts the ability of banks to trade derivatives. It cleans up the whole business of derivatives by moving the trading into clearinghouses and onto exchanges where it will be transparent and properly capitalized. And it creates a new consumer protection agency, albeit within the Federal Reserve, with the power to crack down on shady mortgages, credit card practices, payday lenders and other financial services.

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