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ANALYSIS: Finance Bill Misses the Mark: We need to restructure Wall Street, not just regulate it

Robert Reich Jun 3, 2010

 

The most important thing to know about the 1,500-page financial reform bill passed by the U.S. Senate on May 20 — now on the way to being reconciled with the House bill — is that it is regulatory. It does nothing to change the structure of Wall Street.

The bill omits two critical ideas for changing the structure of Wall Street’s biggest banks so they won’t cause more trouble in the future, and leaves a third idea in limbo. The White House does not support any of them.

First, although the Senate bill seeks to avoid the “too big to fail” problem by pushing failing banks into an “orderly” bankruptcy- type process, this regulatory approach is not enough. The Senate roundly rejected an amendment that would have broken up the biggest banks by imposing caps on the deposits they could hold and on their capital assets.

You do not have to be an algorithm-wielding Wall Street whiz-kid to understand that the best way to prevent a bank from becoming too big to fail is preventing it from becoming too big in the first place. The size of Wall Street’s five giants already equals a large percentage of the U.S. gross domestic product.

That makes them too big to fail almost by definition, because if one or two get into trouble — as they did in 2008 — their demise would shake the foundations of the financial system, even if there were an “orderly” way to liquidate them. Because traders and investors know they are too big to fail, these banks have a huge competitive advantage over smaller banks.

Another crucial provision left out of the Senate bill would be to change the structure of banking by resurrecting the Depression-era Glass-Steagall Act and force banks to separate commercial banking (the classic function of connecting lenders to borrowers) from investment banking.

WHY DERIVATIVES MATTER

Here, too, the bill takes a regulatory approach instead. It includes a provision barring banks from “proprietary trading,” or making market bets with their own capital. Even if this regulation were tough enough (and the current Senate bill requires various delays and studies before it is applied), it would not erode the giant banks’ monopoly over derivatives trading, adding to their power and inevitable “too big to fail” status.

Which brings us to the third structural idea, advanced by Senator Blanche Lincoln (D-Ark.). She would force the banks to do their derivative trades in entities separate from their commercial banking.

This measure is still in the bill, but is on life-support after former Federal Reserve chairman Paul Volcker, Treasury Secretary Tim Geithner and Fed Chair Ben Bernanke came out against it. Republicans hate it. The biggest banks detest it. Virtually every major Wall Street and business lobbyist has its guns trained on it. Almost no one in Washington believes it will survive the upcoming conference committee.

But it’s critical. For years the big banks have relied on taxpayer-funded deposit insurance to backstop their lucrative derivative businesses. Obviously they want the subsidy to continue. Bernanke argues that “depository institutions use derivatives to help mitigate the risks of their normal banking activities.” True, but irrelevant. Lincoln’s measure would allow banks to continue to use derivatives. They just could not rely on their government-insured deposits for the capital.

Wall Street’s lobbyists have fought tooth and nail against these three ideas because all would change the structure of America’s biggest banks. The lobbyists won on the first two, and the Street has signaled its willingness to accept the Dodd bill, without Lincoln’s measure.

The interesting question is why the President, who says he wants to get “tough” on banks, has also turned his back on changing the structure of U.S. banks — opting for a regulatory approach instead.

It’s almost exactly like healthcare reform. Ideas for changing the structure of the healthcare industry — single payer, Medicare for all, even a so-called “public option” — were all jettisoned by the White House in favor of a complex set of regulations that left the old system of private for-profit health insurers in place. The final healthcare act doesn’t even remove the exemption of private insurers from the nation’s antitrust laws.

Regulations do not work if the underlying structure of an industry — be it banking or healthcare — got us into trouble in the first place. Wall Street’s big banks are just too big, and their ability to draw on commercial deposits for investment banking activities, including derivatives, will make them even bigger. It will also subject the economy to greater and greater risks in the future. No amount of regulation can cure that.

Similarly, the underlying system of private for-profit health insurance is a key driver of America’s bloated and ineffective health care delivery. We can try to regulate it like mad, but no amount of regulation will cure this fundamental problem.

LOOPHOLES

A regulatory, rather than structural approach, to deep-seated problems in complex industries like banking and healthcare is also vulnerable to the inevitable erosion that occurs when industry lobbyists insert themselves into the regulatory process. Tiny loopholes get larger. Delays get longer. Legislative words are warped and distorted to mean what industry wants them to mean.

Both Senate and House financial reform bills exempt “customized” derivatives from the exchanges, for example, but leave it to regulators to define what contracts will be excused. Yet many of the derivatives that caused the most trouble (read: Goldman Sachs’ and other banks’ deals with AIG) might well be thought of as customized. Another potential problem: In assigning consumer protection to the Fed, the bill puts it under Fed chiefs who in the past displayed a patent disregard for such safeguards (read: Alan Greenspan).

Inevitably, top regulators move into the industry they are putatively trying to regulate, while top guns in the industry move temporarily into regulatory positions. This revolving door of regulation also serves over time to erode all serious attempts at overseeing an industry.

The only way to have a lasting effect on industries as large and intransigent as banking and healthcare is to alter their structure. That was the approach taken to finance by Franklin D. Roosevelt in the 1930s, and by Lyndon Johnson to healthcare (Medicare) in the 1960s.

So why has Obama consistently chosen regulation over restructuring? Because restructuring Wall Street or healthcare would surely elicit firestorms from these industries. Both are politically powerful, and Obama did not want to take them on directly.

A regulatory approach allows for more bargaining, not only in the legislative process but also, over time, in the rule-making process as legislation is put into effect. It is always possible to placate an industry with a carefully chosen loophole or vague legislative language that will allow the industry to go on much as before.

And that’s precisely the problem.

Robert Reich served as U.S. Secretary of Labor from 1993 to 1997. This article was adapted from a longer version originally published on robertreich.org.

pewpoll

Americans are constantly reminded about both the wonders of capitalism and the dangers of socialism. However, a recent poll by the nonpartisan Pew Research Center indicates that a lot of people still aren’t getting the message.

The nationwide survey, which tested reactions to words and phrases frequently used in current political discourse, found that only slightly more than half the public (52 percent) reacts positively to the word “capitalism” compared to 37 percent who say they have a negative reaction. Fewer than half of young people, women, people with lower incomes and those with less education react positively to “capitalism.”

Despite being almost nonexistent as a political force in the United States, “socialism” received an overall positive rating of 29 percent. Young people (ages 18-29) were equally divided with 43 percent reacting positively to the word “socialism” and 43 percent having a positive reaction to “capitalism.”

The poll was conducted from April 21 to 26 and was composed of a random sampling of 1,546 people.

—JOHN TARLETON

DEAN BAKER: DEMAND ACCOUNTABILITY

The same people who caused this disaster are still calling the shots. Specifically, there has been little change in personnel and no acknowledgment of error at the central banks whose incompetence was responsible for the crisis.

Remarkably, this crew of incompetents is still claiming papal infallibility, warning governments and the general public that bad things will happen if they are subjected to more oversight. Instead, the central bankers and their accomplices at the International Monetary Fund (IMF) are dictating policies to democratically elected governments. Their agenda seems to be the same everywhere, cut back retirement benefits, reduce public support for healthcare, weaken unions and make ordinary workers take pay cuts.

Before anyone listens to Federal Reserve Chairman Ben Bernanke, European Central Bank President Jean-Claude Trichet or IMF Managing Director Dominique Strauss-Kahn, they should first be forced to tell us when they stopped being wrong about the economy. We cannot afford to let these subprime central bankers control economic policy any longer.

Excerpted from an article that was originally published on Huffington Post (huffingtonpost.com). Dean Baker is the co-director of the Center for Economic and Policy Research (cepr.net) in Washington, D.C.

MARK WEISBROT: CLASS AND THE EURO-CRISIS

In mid-May, the Euro was plummeting because the financial markets wanted more blood: They wanted Greece, Spain, Portugal and the other currently victimized countries of Europe (Italy and Ireland) to commit to more spending cuts and tax increases. Then they got what they wanted, and within a day or two, the Euro started crashing again because “the markets” discovered that these procyclical policies would actually make things worse in the countries that adopted them and reduce growth in the whole Eurozone.

Unfortunately the European authorities — especially the European Central Bank — are even worse than the markets. They are less ambivalent and more committed to punishing the weaker economies by having them cut spending even if it causes or deepens recession and mass unemployment (over 20 percent in Spain).

There is a class dimension to all of this, with the European Union (EU ) authorities and the bankers united in wanting to balance the books on the backs of the workers — and adopt “labor market reforms” that will weaken labor and redistribute income upward for generations to come. The EU authorities and financiers believe that real wages must fall quite sharply in these countries in order to make them internationally competitive — but the protesters are responding with a fiscal version of “No justice, no peace.”

Excerpted from an article that was originally published in the Guardian (guardian.co.uk). Mark Weisbrot is co-director of the Center for Economic and Policy Research.

NOMI PRINS: SHADOW BANKERS

Despite all the noise about financial reform, the shadow banking system that helped create the financial crisis would remain fundamentally unaltered by the legislation now pending in Congress. Indeed, leveraged entities such as private-equity, venture-capital, and hedge funds get only minor regulatory attention.

These barely regulated, nontransparent bastions of speculation propagated systemic risks beyond any that could be created by the banks themselves. Whether housed at banks, created by banks, or freestanding, they exist to enable speculative risk-taking hidden from either regulatory or market scrutiny, while camouflaging layers of debt and enabling the complex-securitization deals that caused the financial collapse.

Yet, neither the House bill passed last December nor the most recent Senate bill does more than impose marginal adjustments on the shadow banking system.

Excerpted from an article that was originally published on The American Prospect (prospect.org). Nomi Prins is a former managing director at Goldman Sachs and author of It Takes a Pillage: Behind the Bailouts, Bonuses, and Backroom Deals from Washington to Wall Street.

DOUG HENWOOD: TIME TO START OVER

The dog-eat-dog model of social Darwinism worked well (on its own terms) while the United States was growing rapidly in the 19th and early 20th centuries, but since growth slowed down in the 1970s, we have been in need of a rethink of the old model. But we are incapable of it. Instead, we have tried ever more reckless applications of debt to keep things going. The recent financial crisis looked like a major affront to that approach, but we are now emerging from the crisis phase without things having changed all that much. The country seems to be rotting from within, but the political and ideological systems are incapable of recognizing that fact.

Excerpted from a lecture Henwood gave at the Studies in Political Economy annual meeting in Ottawa, Canada, in January. He is the editor of Left Business Observer (leftbusinessobserver.com), a monthly newsletter on economics and politics.