By J. Paul Horne
President Obama’s dramatic victory on healthcare reform may have had a collateral impact in kick-starting financial regulatory reform. The conventional wisdom in Washington has been that the high political expenditure on the health bill precluded any other major legislative initiative until after the mid-term elections in November. But the passage of the health bill may have triggered a new political dynamic. Over the weekend, as the bill was passing, Republican Senators, apparently worried by their weakened overall position, withdrew hundreds of amendments to a proposed bill reforming financial regulation. The text, drafted by Senator Chris Dodd, the Democrat who chairs the Senate Banking Committee, was voted out of the committee and onto the Senate floor for debate this week. The move means sudden, largely unexpected progress on an issue in which the post-crisis surge to overhaul the system is pitted against intense lobbying by Wall Street. The Dodd initiative was clearly coordinated with the White House: in his weekly on-line address to the nation on Saturday, President Barack Obama chose to address, not the health-care debate then at its top crescendo, but instead the need for action on financial regulatory reform.
It is now possible that significant reforms aimed at big finance could be voted into law by the summer, although serious obstacles remain. American voters remain furious at Wall Street – and its “Too Big To Fail (TBTF)” financial institutions -- that caused the crisis in 2007-2009. Wall Street, of course, remains determined to block new constraints on “financial innovation” (and profitability), and its allies, notably in the Republican opposition, are keeping their efforts on the boil.
Meanwhile, coordination of U.S. and European Union (EU) regulatory reform, aimed at protecting the global economy from a repeat of the recent finance-led crash, has encountered new problems – notably infighting in the EU stemming from the fiscal crises in some EU countries. The debt woes of Greece and the other PIIGS (Portugal, Ireland, Italy and Spain) – all countries in the eurozone – are now liable to be matched by similar problems in Britain, which has sought to protect The City by staying out of the euro. All are threatened now that the Greek crisis has focused markets’ attention on the fiscal problems and default risks of so many EU nations. As a result, all these governments are being forced by the market to pay significantly more to borrow funds to roll over their debts -- thus causing the euro to depreciate against the dollar.
Now there is talk of a “rift” between the Federal Reserve and the European Central Bank (ECB). The Fed has started to tighten monetary policy to avoid inflationary risks as the U.S. recovery gains pace, but the ECB may not yet be able to start moving in the same direction: it has to take into account the slower European economic recovery and also cope with the fiscal tightening caused by the debt crisis in EU countries. In this situation, interest rates may start to rise sooner in the U.S. than in the EU. If U.S. interest rates rise further above Euro-zone rates, it could cause the dollar to rise against the euro, making make it harder for the U.S. and EU to stay on the same page in pursuing financial regulation. That would jeopardize prospects for internationally-coordinated regulation, a goal that the G-20 countries have agreed is essential.
In the U.S., Wall Street appears to have headed off the most drastic proposals to tighten supervision of banking, insurance and non-bank finance (the so-called “shadow banking industry”) that were proposed late last year by Dodd himself. The influential TBTFs and their supporters also seem to have fended off the structural changes proposed by former Fed Chairman Paul Volcker. These would have separated the activities of depository and risk-taking banks, notably by forbidding deposit-taking banks from doing risky “proprietary trading” using clients’ deposits but allowing financial houses to take greater risks with their own capital. Proprietary trading brought huge profits during the bubble years but put depository institutions at risk of bankruptcy as markets collapsed in 2007-2009. The proposals by Paul Volcker, a former Fed chairman who at times seemed to be Obama’s most influential economic adviser, included steps to cut TBTFs down to size and also imposed new taxes and fees on transactions and balance sheets.
But his ambitious plans seem to have been partially sidelined by Dodd’s with “second-effort” draft, which seems to be aimed at producing legislation strong enough to assuage public demands for reform action but not so radical as the more draconian Volcker plan. Dodd took personal charge of the issue after announcing that he will not stand for re-election, a decision he took after disclosures depicted him as a crony of banking and insurance circles. His new text – which is clearly supported by his Democratic party but has backed away from measures that Wall Street deemed unacceptable -- was approved with unexpected speed, with Republicans on the committee dropping their previous obstructionist tactics. This shift, to accept at least some version of reform, may reflect current U.S. polls showing 60-70 percent of voters registering anger at Wall Street bailouts. Wall Street also faces the new “Tea Party” protests of angry libertarian conservative voters who object to big government, taxes and bailouts. This revolt against Wall Street is fueled by the on-going spectacle of unrepentant financial executives awarding themselves huge bonuses at companies that needed tax-payer bail-outs – just as these same bailed-out banks are reporting record profits while cutting loans to the real economy.
A new financial regulatory structure thus seems possible, but the revised legislation proposed by Dodd will still have to be merged with the House’s reform bill approved last December. Shorn of some more drastic regulatory constraints originally proposed last year, the 1336-page Senate bill still provides a number of key regulatory innovations which would mark a major improvement in the structure of U.S. financial regulation. These include:
1) A Financial Stability Oversight Council, representing all federal regulators and chaired by the Treasury Secretary, would identify and avoid systemic risk;
2) A Consumer Financial Protection Bureau would be based in the Fed, but will have an independent head and budget;
3) A “resolution” process to liquidate failing TBTF institutions expeditiously and a $50 billion fund paid for by the banks to bail out TBTFs;
4) Regulation of over-the-counter markets for “financial derivatives´ by the Security and Exchange Commission and the Commodities Futures Trading Commission; with more transparency and accountability;
5) Restrictions on risk-taking by banks using depositors’ funds as opposed to investment banks or non-bank financial companies using risk capital;
6) SEC regulation of rating agencies and hedge funds;
7) Restructuring of U.S. bank regulators; and
8) Creation of an Office of National Insurance in the Treasury Department to monitor insurance companies and propose their federal regulation for the first time.
In the new Dodd bill, the Fed would continue to set monetary policy but with a subtle reduction of its previous independence. The Dodd bill would have the White House name the president of the New York Fed, the most important of the 12 regional Fed banks because it works so closely with the biggest banks. Such a political appointee might politicize to a degree monetary-policy decisions.
More importantly, the bill would limit the Fed’s supervisory authority to the big banks with assets of over $50 billion, i.e. financial companies judged potential systemic risks. That would exclude thousands of the banks which are today members of the 12 regional Federal Reserve Banks and which the Fed supervises. Moreover, if the Fed lost its right to monitor these banks’ market operations, its intimate knowledge of markets would be impaired, a serious limitation on its ability to set monetary policy.
In contrast to the more positive outlook for U.S. regulatory reform, the odds are lengthening against transatlantic coordination of U.S. reforms with those sought by the European Commission (EC). Last December, the EC put forward well thought-out proposals to coordinate effective regulation of banking, insurance and the shadow banking industry in the 27-nation EU. But the fiscal crisis involving the whole EU with the problems of Britain and the PIIGS has led to sharp differences between the German, French and British governments. One issue is German interest in bringing in the International Monetary Fund to straighten out Greece, an idea that seems valid because if the EC, as the executive arm of the EU, attempts to discipline Greece it might well run into serious political pressures which would further drastically weaken the credibility of the EU and the euro. Another serious split pits Germany and France – which insist on tighter regulation of any financial institution operating in the EU, including those based in the U.S. and non-EU countries -- against the U.K. which fears such regulation would cause such companies to abandon The City, Europe’s effective financial capitol.
J. Paul Horne is an Independent International Market Economist
JPH12Econ@verizon.net