Sunday, March 28, 2010

Financial Reform

More than a year after the 2008 financial collapse Senate Banking Chair Christopher Dodd of Connecticut made a formal release of a proposed financial reform bill. Senator Dodd directed his Banking Committee staff to up load an Acrobat summary of the bill, which is 12 pages and titled “Restoring American Financial Stability.”

The bill intends to create three new independent agencies: the Consumer Financial Protection Agency, the Agency for Financial Stability, the Financial Institutions Regulatory Administration.

It intends to create a new Office of National Insurance at the Department of the Treasury and a new Office of Credit Rating and an Office of Investor Advocate at the Securities and Exchange Commission.

Many of the duties and authorities of the agencies are combined from other existing offices and agencies, especially the Federal Reserve Bank. Under the new bill the Federal Reserve Bank would continue to manage monetary policy and be the lender of last resort, but it would lose many of its consumer and bank regulatory duties.

New duties for the new agencies include authority for the Securities and Exchange Commission (SEC) to regulate derivatives and hedge funds. New SEC duties give authority to examine credit rating agencies, disclose their methodologies and track record and deregister an agency. There are new proposals to regulate municipal securities advisors and dealers with enforcement through the SEC.

The bill provides for an annual assessment of the Securities and Exchange Commission, an apparent attempt to regulate the regulators, where an Investment Advisory Committee will watch over SEC practices and priorities along with a new Office of Investor Advocate.

There are more changes in corporate governance and shareholder rights and a page with the caption “Ending Too Big to Fail” describing new requirements for “limiting large, complex companies and preventing future bailouts.”

Back in 1998 the director of the Commodities Futures Trading Commission, a women named Brooksley Born, argued derivatives should be regulated because banks were taking risks lending money to hedge funds to buy derivatives. To shut her off Congress passed legislation prohibiting the Commodity Futures Trading Commission from writing new rules to regulate derivatives.

A review article [“What went Wrong” Washington Post, 10/15/2008] from last fall quotes former Federal Reserve Chair Alan Greenspan: “Regulation of derivative transactions that are privately negotiated by professionals is unnecessary.”

Apparently Congress agreed with Alan Greenspan that professionals are infallible, but that was in 1998. Now they think they are greedy and irrational and need to be controlled with new agencies and regulations.

Truth is that nothing has changed from the 1990’s or the 1930’s. Financial crises occur because banks only hold a fraction of deposit liabilities in reserve to pay for checks. If banks make enough risky loans for things like derivatives that default they will not be able to clear checks for account holders who need to make payments. Unless there is a bailout, business transactions will halt and the economy will collapse.

Back in the 1930’s there were many gamblers who took risks and bought stocks with borrowed money. After many banks failed Congress passed the National Banking Act of 1933 and the Securities and Exchange Act of 1934, which included Federal Reserve authority to set Margin Requirements: requirements that limit the percentage of borrowed funds to buy financial assets.

Margin requirements are still available for use as they have been since the 1930’s. If Congress thinks derivatives are not covered by Margin Requirements a sentence or two of revision in the regulations would take care of it.

Perhaps a 1,100 page bill reflects a Congressional mania for grandiose solutions, but I have to wonder about their motivation. Do they really want to regulate their friends on Wall Street? We will see.

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