Wall Street's Winning Financial Reform Battle May Change

According to a post by Henry Blodget on Yahoo, 'Wall Street Won! Nothing to Prevent Another Crisis, says Former FDIC Chairman Bill Isaac'.

Crisis may create opportunity, but Congress completely flubbed its opportunity to enact meaningful financial reform in the aftermath of the worst crisis since the Great Depression, says the former chairman of the FDIC, Bill Isaac. 

The Dodd-Frank reform bill--the one major piece of legislation to emerge since the financial crisis--is mostly meaningless, says Isaac, who is also the chairman of regional bank Fifth Third.  Dodd-Frank does nothing to address the root causes of the financial crisis, Isaac says, and it won't prevent the next one. 

 According to an article by Floyd Norris in the NY Times, the 'Crisis is Over, But Where's the Fix?'

... the International Monetary Fund ... researchers this week concluded that the rescues “only treated the symptoms of the global financial meltdown.” 

The researchers, Stijn Claessens and Ceyla Pazarbasioglu, warned that “a rare opportunity is being thrown away to tackle the underlying causes. Without restructuring financial institutions’ balance sheets and their operations, as well as their assets — loans to over-indebted households and enterprises — the economic recovery will suffer, and the seeds will be sown for the next crisis.” 

Clearly, Wall Street has been winning the financial reform battles.  In seeking to explain why Wall Street is winning, Mr. Norris highlights two facts.

[1]... “If we ask [the banks] for more capital, and they are too big to fail, they can take even more risk” after they raise additional capital, Y. Venugopal Reddy, a former governor of India’s central bank, argued at an economic conference sponsored by the I.M.F. this week. 

[2]  He added that he was worried about institutions that were “too powerful to regulate.”

Mr. Norris then points out what needs to be fixed:

... there is also the fact that the financial system did not accomplish what it was supposed to do. “At the core of these functions is the ability to find and set the right price, including the extent to which it reflects risk,”Antonio Borges, an I.M.F. official and former vice chairman of Goldman Sachs International, told the conference. “This is not really a question of financial sophistication, of complex products or greedy bankers. It is a question of getting the prices wrong.” 

He added, “It is unbelievable how wrong they were.” 

There is general agreement that many of the assumptions economists and others made before the crisis — about the rationality of markets, about their ability to measure risks and about the proper role of monetary policy — were largely wrong, or at best oversimplified. 

But there is far less unanimity about what to do about it. International cooperation was impressive in dealing with the immediate crisis. Now it is splintering, and banks are threatening to move operations to areas they deem friendlier to them. 

As regular readers of this blog know, the FDR Framework provides the fix that Mr. Norris is looking for.  It answers the question of why prices and the assumptions made about how the markets operate were wrong.

Simply put, the FDR Framework predicted and the credit crisis showed that prices will be wrong and markets will not function if investors do not have access to all the useful, relevant information in an appropriate, timely manner.

Mr. Norris concludes by focusing on a potential flaw in any regulatory system.

... regulatory failures may be inevitable. If multimillion-dollar bank bosses do not see a crisis looming before it is too late, can we be sure regulators who work for far less will be more prescient? 

Markets clearly did a horrid job of allocating capital, but there is no particular reason to think governments would do better. 

Even if regulators somehow did design a perfect regulatory system, it would not last, simply because clever bankers would eventually find ways around it, just as people find ways to evade taxes, forcing tax law writers to constantly make changes. 

“Every decade or so,” said Paul Romer, a senior fellow at the Institute for Economic Policy Research at Stanford and now a visiting professor at New York University, “any finite system of financial regulation will lead to systemic financial crisis.” 

If he is right, it is all the more important that ways be found to assure that the costs of the next financial crisis — in failed institutions and lost economic growth, not to mention government borrowing — will be far lower. It is hard to conclude much progress has been made in accomplishing that goal.

Fortunately, legislation passed in the US and Europe has effectively eliminated this flaw and is driving the US and Europe to an FDR Framework based regulatory system.

In the US, the legislation took the form of requiring the removal of the rating agencies from all regulations.  Without ratings to rely on, investors are forced to do their own homework.  The only way this can be done is if they have access to all useful, relevant information in an appropriate, timely manner.

In Europe, the legislation took the form of requiring financial institution investors, both commercial and investment banks, to know what they own.  Again, the only way for these institutions to show they know what they own is if they can access all useful, relevant information in an appropriate, timely manner.