The Missing Wall Street Debate

Michael Stephens | October 16, 2012

In a 90-minute debate, I’m not sure it’s possible to cover every single issue of pressing national importance and to do so in coherent detail.  So the following is a complaint one could make about a number of issues that were missing from last Thursday’s VP debate, but it was a little eyebrow-raising that financial reform was absent from the conversation.

Sure, the collapse of Lehman is ancient history as far as the political news cycle is concerned, and regulatory details can sometimes come off as unbearably technical to the average viewer.  However, we are still living through the real-world economic consequences of a massive global financial crash; the ink on the 2010 Dodd-Frank Act is not yet dry (key regulations are still being finalized); and recent scandals should have reminded us that the soundness of the financial system cannot be taken for granted.

Hopefully, tonight’s presidential debate will feature a little more recognition of the catastrophic regulatory failure we’re still living with.  We’ll see.  At this year’s Minsky conference, Gillian Tett of the Financial Times joined a panel discussion (with Louis Uchitelle, Jeff Madrick, and Yalman Onaran) on the role of the press in the financial crisis and financial reform efforts (audio here).  Tett commented on the failure of the press to focus on what was really going in finance in the run up to the crisis, and one of the challenges she identified here was what she labelled the “complexity problem”:  the key activities in advance of the crisis, in derivatives for example, were poorly understood, and now, after the crisis, we have a regulatory response in Dodd-Frank that’s even more complex and opaque.

This issue of complexity isn’t just a challenge for the press.  It’s also a public policy problem.  Jan Kregel argues that the more recent JPMorgan and LIBOR scandals demonstrate that the financial conglomerates involved are “too big to manage” and too big to regulate effectively.  This isn’t a fact of nature.  This is the financial system we have built.  Whether we’re able to make informed public choices about the future of financial regulation is also bound up with the question of whether we will have a financial system whose operations can be readily supervised and understood.

One of the key regulatory challenges going forward is to figure out how to bring to the banking system the sort of simplification that the 1933 Glass-Steagall Act delivered.  Kregel highlights this observation by Hyman Minsky regarding one of the underrated sources of Glass-Steagall’s strength:  “the scope of permissible activities by a depository institution was to be limited to what examiners and supervisors could readily understand,” Minsky wrote, “… [I]t was not so much the differences in riskiness as it was the ease of understanding the operations that led to the separation of investment and commercial banking.”  For Kregel, it isn’t the specifics of Glass-Steagall’s restrictions that serve as a model for how we should replace Dodd-Frank—as he explains here, we can’t simply go back to Glass-Steagall—but the simplification and transparency the law offered, which made it easier for regulators and examiners to understand what was going on inside these institutions.*

Dodd-Frank doesn’t appear to offer the relevant simplification, and the rule-making process isn’t making the law (or the banking system) any less complex.  Unfortunately, the reigning political alternative to Dodd-Frank, offered by the candidate currently leading in a number of national polls, is to repeal Dodd-Frank and replace it with [insert boilerplate].  We’ll see tonight whether the candidates have anything to say about financial reform that comes close to facing up to these problems.

* Kregel also observes that while Dodd-Frank tries to limit the riskiness of certain activities, it doesn’t fundamentally challenge the dominance of a business model in which banks’ central activity is to make money off of changes in the prices of assets in their portfolios.  The problem with this model is not just that it’s risky, but that these are the “wrong risks,” as Kregel puts it—they do little to increase real output and employment.  Directing banks to make the right risks was another strength of the Glass-Steagall framework, according to Kregel:

… Glass-Steagall was designed to direct bank lending toward the financing of investment in productive activities that would generate future income and employment. The risks that a bank incurred in this scenario were linked to the ability of entrepreneurs to identify investment opportunities that would produce an income stream sufficient to pay back the loan and earn a competitive market rate of return. Here, the risk concerned the income generated by the project being financed, and such projects required the employment of labor and the production of real output for the market. A bank’s activities thus benefited not only its shareholders but also entrepreneurs and workers.

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  1. Comment by Ralph MusgraveOctober 17, 2012 at 3:13 am   Reply

    Glass-Steagall is useless in that it doesn’t save “High Street only” or “retail only” banks like Northern Rock.

    There is actually an extremely simple solution to all this: just make sure that ALL loans and investments made by banks are covered by loss absorbing bank creditors (shareholders, bondholders and loss absorbing depositors). That way, banks as such cannot fail (bar blatant criminality).

    What I mean by “loss absorbing depositors” is that if a depositor wants interest on their money (i.e. wants their bank to invest or lend on their money), the depositor can sod*ing well carry the loss if the investment or loan goes bad.

    I applaud those who take commercial risks, like investing or having someone else invest their money. But it’s not the job of the taxpayer to carry one cent of the risk.

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