I cadged this, lock, stock and barrel, off BaselineScenario, because it is such a good piece of critical journalism, the kind of thing that should be done a lot more of; nd because the subject is so topical. Geithner and Summers have proven to be predictably 'reliable' vulpine sentries at the chicken-coop. The author is Simon Johnson, and he takes Timmy & Larry out behind the barn and provides some needed instruction:
Writing in the Washington Post this morning, Tim Geithner and Larry Summers outline a five point plan for dealing with the underlying problems in our financial system, entitled "A New Financial Foundation."And, as I noted at the Baseline site, quite imperturbably comfortable with the PILES of cash with which they'll have amply and lavishly feathered their own palatial nests.
The authors are not completely clear on what they think caused the current crisis, but you can back out some points from their reasoning – and the implicit view seems quite at odds with reality.1. Their view: Regulation is overly focused on safety and soundness of individual banks. Reality: There was a complete failure of safety and soundness supervision. This must be fundamental to any financial system – without this, you’ll get mush every time.And of course the complete omissions from this document are breathtaking. No mention of executive compensation or the structure of compenstion within the financial sector. Not even a hint that the complete breakdown of corporate governance at major banks contributed to execessive risk taking. And no notion of regulatory capture-by-crazy-ideas of any kind.
2. Their view: “A few large institutions can put the entire system at risk,” so we need a system regulator. Reality: you need to control the behavior of large institutions, more than a few of which got us into this mess. If you can’t come up with a proposal to prevent them from taking system-damaging risk (and there is nothing in today’s article about this), then break them up. The article mentions penalties for being large - higher capital and liquidity requirements for larger banks; we’ll see the details in/after Geithner’s speech tomorrow, but I am not holding my breath for anything meaningful.
3. Their view: All large firms will be subject to consolidated supervision by the Federal Reserve and there will be a council of supervisors. Reality: we have plenty of layers, up to “tertiary” regulators (and beyond, in some senses) and there is already enough opportunity for regulatory arbitrage. What prevents the biggest banks from capturing or manipulating regulators? There is no mention in today’s document of the extent to which everyone, including the authors, believed in the big banks’ risk management abilities last time – and continue to rely on the advice of their people today.
4. Their view: The originator “of a securitization” will be required to “retain a financial interest in its performance.” Reality: It was a big unpleasant shock when everyone realized that Lehman, Bear Stearns, and others had retained a large exposure to dubious financial products, some of which they had issued. We are back to the Greenspan fallacy here – if financial firms have an incentive not to screw up on a massive scale, they won’t.
5. Their view: “[T]he administration will offer a stronger framework for consumer and investor protection across the board.” This sounds incredibly vague and may be the worst news today. It looks like they are backing away from the idea of a Financial Products Safety Commission, for example as proposed by Elizabeth Warren.
There are a couple of positive notes towards the end. The administration will seek a resolution authority for dealing with failed banks, but we knew this already. And the authors recognize the need to change how financial systems operate around the world; unfortunately, there is zero detail on this crucial point.
Overall, there are no surprises here. Brick by brick, we are building the foundation for the next financial crisis; by all indications, it will be more disruptive and a great deal more damaging than the crisis of 2008-09. But presumably by then the authors will be out of office.
UPDATE (2:49 PM, MDT): Robert Reich offers three absolutely essential reforms, to prevent what Johnson describes above as the findation of the next crisis/bubble:
What is striking is the degree to which Reich's quite sensible injunctions are absent from the prescriptions of the Geithner/Summers Plan, nest paw?
1. Stop bankers from making huge, risky bets with other peoples’ money. At the least, require they back their bets with a large percentage of their own capital, and bar them from raising money off their balance sheets through derivative trades. Also require they take their pay in stock options or warrants that can’t be cashed in for at least three years, so they’ll take a longer-term view. Best of all would be a requirement that investment banks return to being partnerships and the capital on their books be their own, not yours or your pension fund’s. When investment banks were partnerships, every partner took an active interest in what every other partner and trader was doing. The real mischief started once they started selling shares to the public.
2. Prevent any bank from becoming too big to fail. Separate commercial from investment banking, as they were before the late 1990s. Commercial banks should return to their basic function of linking savers with borrowers. Investment bankers should return to their casino function of placing bets in the stock market and advising you and others about where to place your own own bets. Combining the basic utility with the casino only made bankers far richer and subjected you and me to risks we didn’t bargain for. If separating commercial from investment banking isn’t enough to bring all banks down to reasonable size, use antitrust laws to break them up.
3. Root out three major conflicts of interest. (1) Credit-rating agencies should no longer be paid by the companies whose issues are being rated; they should be paid by those who use their ratings. (2) Institutional investors like pension funds and mutual funds should not be getting investment advice from the same banks that profit off their investments; the advice should come from sources without a financial stake; (3) the regional Feds that are responsible for much bank oversight should no longer be headed by presidents appointed by the region’s bankers; non-bankers should have the major say, and the regional presidents should have to be confirmed by the Senate.