Red and Blue
Financial Regulatory Reform
Arnie Arnesen and Michael Krull
Since it feels like it has been so long since a financial institution exercised their fiduciary duty we may have forgotten what the term fiduciary entails: an obligation to act in the best interest of another party … whenever the relationship with the client involves a special trust, confidence, and reliance on the fiduciary to exercise discretion or expertise in acting for the client.”
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D. Arnie Arnesen is a radio and TV commentator based in New Hampshire. She has lectured at Harvard, Dartmouth, UNH, SNHU, Vermont Law School, St. Olaf, and other colleges. She is a former NH Legislator and a former democratic nominee for Governor and Congress. Arnie has been a Fellow at the Kennedy School of Government's Institute of Politics at Harvard and has trainied women who want to run for office throughout the United States and future NH Leaders. You can hear Arnie every Wednesday on Talk of Iowa on IowaPublicRadio.org and every Friday on the Dan Mitchell Show on WKBKam.com. politicalchowder@gmail.com
RED
Financial Reform
By Michael Krull
Our economy has recently experienced the consequences of excessive risk-taking by financial enterprises, real estate speculators and overstretched homeowners, fueled by the expectation that taxpayers would cover their losses if risky bets failed. Our government’s response to these activities has confirmed these expectations, thereby compounding the problem for the future.
When the government financially assisted the sale of Bear Sterns to JP Morgan Chase in March 2008, the market’s assumption that the government would stand behind (bailout) financial institutions whose housing and other credits had gone bad, were confirmed. When the government then let Lehman Brothers fail in September 2008, markets were confused and went into shock.
Our government must give up the conceit that it can reliably micromanage socially desired outcomes. Recovery of the U.S. economy and of the financial sector that finances it requires stabilizing the rules of the game and restoring market discipline surrounding risk taking. The regulatory rules must return the cost and reward of risk taking from the taxpayer to the risk taker.
The moral hazard of financial risk takers – taking the profits on the way up with taxpayers bailing them out when their bets fail – has seriously corrupted our financial system. These government policies have seriously distorted the incentives (which we’ll talk more about later) faced by leading financial firms, leading to far too much leverage and risk taking in the financial sector.
Let’s pause to consider how some financial firms got so big in the first place. Markets and investors price risk; they demand a risk premium (higher return) for investments with higher risks of losses. Banks, for example, hold capital (funds put up by owners/depositors) to protect depositors from any losses of their funds lent or invested by the bank. The safer the bank’s loans or investments, or the larger its capital, the safer are its depositor’s funds.
In the 19th Century, American banks held capital of almost 25 percent of their assets on average and a similar amount of assets were invested in very safe and liquid instruments such as cash in their vaults and government securities. Such conservatism was necessary to assure depositors that their funds would be safe. Before the financial crisis of the past two years, American banks held core capital of around 6 percent. Why the change? The Federal Reserve was established to provide a lender of last resort to banks, thus reducing their need for liquid assets. The broadening and deepening of secondary trading of financial assets had the same effect, and the introduction of deposit insurance (FDIC) reduced depositor concerns about their banks and their money’s safety.
Market and government measures that reduced banking risks led banks to take more risks to maintain the balance between risk and return desired by their depositors and the market. To a large extent, this was good for the economy because it lowered the cost of financial intermediation (the spread between deposit and loan rates). But, as we have recently seen, banks took on too much risk. The expectation in the marketplace that government (taxpayers) will pick up the losses by bailing out failing banks if too many risky investments go bad, added a further incentive for banks to increase the riskiness of their investments (heads they win; tails the taxpayers lose).
The perception that a bank or financial institution is “too big to fail” is yet another source of moral hazard, encouraging additional risk taking by these institutions. As we have seen with both Fannie Mae and Freddie Mac (so-called Government Sponsored Entities or GSEs), this implicit government guarantee allowed them to borrow in the market at lower interest rates that their “competitors” in the private market, and enabled them to grow dangerously large. Plus, though we, the taxpayers, are on the hook for the $127 billion that the federal government has lent them since the housing crash (more, by the way that was ever lent to private financial firms), the loan does not appear in the government’s accounting of debt; in other words, this is off-the-books spending and debt.
Firm failure and exit is an important aspect of how markets regulate risk taking and the quality of service. No financial firm should enjoy the government guarantee of being “too big to fail.” There is broad agreement about this in the general public and in Congress, but less agreement about what to do about it. Overly big financial institutions can be broken up, more heavily regulated than other banks, and/or discouraged (via regulation or taxation) from excessive risk taking or becoming so big. The bottom line is this: Safety is not free; the risk taker should bear the full cost of the risk.
In response to the financial crisis, Congress is hard at work. Last year, the House passed a reform package without Republican support. In the Senate, Christopher Dodd (D-CT) is pushing forward a financial reform package that presently has no Republican support. There are rumors that some Republicans (Senators Richard Shelby and Bob Corker are foremost among them) may try to reach a compromise. Each side of the aisle knows that Wall Street is less popular than common criminals and that this is a good election issue.
But there are larger issues at play: What type of society do we want? Do we want a tightly restricted and rule-bound financial sector, or one that is relatively free within clear, well-established boundaries? Do we think that government agencies can regulate the financial system better than the markets?
Pardon the pun, but I’ll put my money on the market rather than government agencies that are too slow to react, can’t properly analyze data and are largely paper-based. Example: In the third quarter of 2008, every government agency predicted that the fourth quarter would have slowing but continued growth – none saw the crash coming. Another example is the Federal Housing Finance Agency that is to provide supervision and regulation of Fannie Mae and Freddie Mac – this is all these several hundred bureaucrats do, yet they could not see the looming housing crisis. Warren Buffet joked that he is better able to evaluate the health of a potential company to purchase over a two-day period of examining the books than this agency was able to do full-time, even though supervising and regulating these two entities is all this agency does.
Because people everywhere, including everyone reading this, seek the best returns on their investments, money naturally flows to areas of stability and predictable rules. A marketplace with the rule of law as its basis, therefore, is much more powerful than arbitrary government regulation punctuated by bureaucratic fiat.
Yet, markets aren’t perfect. Capitalism isn’t perfect, and neither is any other economic system. They are economic systems, not moral systems. However, capitalism is driven mainly by incentives. It is the nexus of service and profit – the better we serve the needs of others the more we profit. Socialism (to take the opposite of capitalism) is the nexus of need and power – those in power politically define what we need and strive to satisfy these perceived needs.
Any economic system works best when the majority of citizens largely embrace the same cultural and moral values. For example, almost all of us work hard to provide for ourselves and our families, and, when possible, to live more comfortably and perhaps even pass something along to the next generation. Most people are also hard wired to please. Once we have satisfied our basic needs, we desire to win approval of our family and friends, and to make the world a better place.
In his new book, “Drive,” Daniel Pink argues that, “the most powerful emotional motivators are the desire of autonomy, the satisfaction that comes from mastering a skill or task, and the need to serve some larger social purpose.” Capitalism better aligns these motivators with economic success. Those people and firms that are most successful in providing other people what they want at the lowest cost are the most profitable and most likely to survive. Capitalism therefore rewards and encourages virtue.
Socialism starts out by proclaiming the virtue of sharing but does not reward it, and thus provides little incentive to achieve it. In its most egalitarian form, it provides no reward for harder work and effort. Power, the control of the levers of government and production, displaces profit as the system’s most tangible reward.
While capitalism’s profit motive rewards and encourages virtue, without supportive moral values it can promote greed. This, coupled with the market distortions brought about by government regulation and uneven enforcement of rules and regulations, led to the financial crisis.
Economists often look at capitalism as directing man’s natural greed (self interest) to the service of the public good (Adam Smith’s famous “invisible hand”). Yet, before he wrote the work in which that phrase appears (“The Wealth of Nations” in 1776), Smith wrote “The Theory of Moral Sentiments” (1759), which provides the ethical, philosophical, psychological and methodological underpinnings to his later works. In it, Smith elaborates his views on the supportive and reinforcing relationship between man’s nature (self-love, reason, sentiment, etc.) and morality (propriety, prudence, benevolence, etc.) and the invisible hand of the marketplace that leads man’s quest for personal gain (profit) to serve the public good.
Whether capitalism tends to promote morality or not, any economic system will perform better if supported by moral values such as mutual respect, compassion and honesty. Our property and our very lives are best protected by the voluntary respect and honesty of our neighbors and those with whom we do business. If everyone (or almost everyone) is honest and does not steal, our property will be protected and we will all be wealthier. If the consequences of breaking this trust is well known and equally applied, the “market” will reinforce this behavior. There is a need for such a balance in today’s discussion of financial regulation, but the discussion needs to be based on hard-nosed economic realities, not on political considerations or social experiments.
Beyond some point, a larger and more intrusive government, responsible for more and more of our needs and behavior, begins to displace and undermine the morality that supports our prosperity. Our sense of self-reliance and personal responsibility begins to give way to reliance on others through state institutions. Profits become more reflective of the ability to gain favors from the state than from satisfying the wants of our neighbors. The incentive for corruption brings forth more corruption. Capitalism begins to slide into socialism.
Regulators failed to prevent excessive risk taking by some financial enterprises and in some respects promoted it. Rather than destroying our financial service industry through over-regulation, the market should be restored to its proper role of pricing and regulating risk taking by financial institutions. A critical element for restoring market discipline is to eliminate the market’s perception that some firms are too big to fail, and to restore the rule of law to its rightful place in policing the market.
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Michael Krull is a graduate of Luther College and Iowa State University. He has worked on disaster relief for the State Department, a major Washington, DC public relations and political consulting firm, and is currently working for American Solutions for Winning the Future. He is a member of the Council on Emerging National Security Affairs.
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Krull suggests that we let banks fail and don't change banking regulation, but he also states that human nature tends to greed and capitalism allows and perhaps encourages it. What to do? Perhaps restrictive rules (Glass-Steagall or something similar) would do. It worked reasonably well for an extended period of time, did it not? There is no real need for the government to be involved in private dealings PROVIDED that the government isn't taking all the risk, and the public, which sees banks as a place to safely plop their money between paychecks, is protected. A bank can't both be a virtual safe deposit box for the masses and a high-profit thrill ride for the owners. P.S. - Some regulators tried to stop the excessive risk-taking by banks, but were thwarted by Congress and their non-career (political) government supervisors. Limiting the governmental influence of those being regulated is the best argument for limiting the size of such institutions. P.P.S - If people were really morally aware with respect to companies, CITI would currently be experiencing a real run - not because of the risk to their deposits, but because customers would find their willingness to let the government bail them out without the board firing all the managers reprehensible.
Andrew Bell
| andrew.bell.ia@gmail.com
| Apr 16, 2010 1:12 PM
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