The Financial Crisis: We Know Enough; Now Let's Do Enough

The Financial Crisis: We Know Enough; Now Let's Do Enough
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William Black, University of Missouri, Kansas City
James Crotty, Department of Economics, University of Massachusetts, Amherst
Jane D'Arista, SAFER & Political Economy Research Institute (PERI), University of Massachusetts, Amherst
Gerald Epstein, Department of Economics, SAFER, & PERI, University of Massachusetts, Amherst
Thomas Ferguson, Department of Political Science, University of Massachusetts, Boston & Roosevelt Institute
Michael Greenberger, University of Maryland
Jennifer Taub, Isenberg School of Management, University of Massachusetts, Amherst
Zephyr Teachout, Fordham Law School

The New York Times recently reported that "some academics" assert that the Senate financial reform bill now under consideration is misguided, while others disagree. We strongly dispute the article's central premise: that we don't know enough about the causes of the crisis.

Many observers anticipated the calamitous effects of radical deregulation as it was occurring. Their warnings only rarely made it into the Times and other major newspapers. We and others warned that deregulation would lead to a fragile, highly-leveraged system of interconnected banks and shadow banks that lacked external checks either in the market or in the government.

That is why we are prepared to support an amended version of the financial reform bill under consideration now in the Senate. Contrary to the assertions in the article, the bill in the Senate, which currently has some effective features, can readily be amended to address key causes of the financial crisis. Here are some specifics:

Reliance on volatile short-term funding: Over the decade from 1997 to 2007, financial sector liabilities rocketed from 63.8% to 113.8 % of GDP. Most of this spectacular growth derived from short-term borrowings from other financial institutions, through commercial paper, repurchase agreements, and other non-deposit funding sources. This system, enabled by deregulatory policies which many observers opposed, led to a run on the financial industry by the industry itself in the fall of 2008. Fortunately, the Wall Street reform bill addresses interconnectedness in Section 610 of Title VI, which limits national banks' exposures to financial counterparties. It also mandates heightened credit exposure reporting by systemically risky banks and non-banks. The Brown-Kaufman SAFE Banking Act amendment would put a hard cap on short-term funding exposure through a 2% GDP limit on non-deposit liabilities.

Unregulated derivatives trading: Scarcely anyone disputes that the decision to prohibit regulation of over-the-counter derivatives in 2000 led directly to the financial meltdown. The bills under consideration would require: exchange-trading and clearing of most standard derivatives; the prudential regulation of major swaps dealers, including capital reserves requirements and business conduct rules; the spinning off of risky swaps desks from the systemically risky banks; and the ability of regulators to ban swaps that lead to financial instability or have no economic purpose. To prevent future crises, the current bill should be fortified to further regulate over-the-counter derivatives: it should close loopholes for foreign-exchange-traded derivates and non-financial end users. These loopholes scarcely justify throwing out the legislation; they simply require amendments.

Unregulated shadow banks: Key market participants, from AIG and Bear Stearns to CIT and GE Capital, were non-bank financial institutions unattached to the federal regulatory apparatus (that is, until they needed bailouts from the Fed and the FDIC). This lack of prudential regulation led directly to the collapse or bailout of multiple "shadow banks." For the first time, the bill mandates the regulation of systemically-risky non-bank financial institutions.

Proprietary trading: Risky proprietary investments by investment banks, along with trading for clients whose decisions were influenced by these banks, was one of the main forces that sustained upward pressure on security prices in the bubble. Indeed, by running large trading books, banks had inside information on client trading patterns and could use that information to front-run, and thereby help sustain market trends. The Volcker Rule will ban proprietary trading in bank holding companies and subject non-banks with proprietary trading operations to enhanced supervision and regulation. To further strengthen these rules, the Merkley-Levin Amendment needs to be passed to tighten and broaden the Volcker restrictions and to further rein in conflicts of interest between investment houses and their clients.

Excessive leverage: Many banks undertook extremely leveraged positions - some greater than 30 to 1 - which brought many of them to the brink of insolvency and beyond. Both the House bill and the SAFE Banking Act amendment to the Senate bill would require that leverage be reduced significantly.

Heads I win, tails you lose banker compensation systems: Bank "rainmakers" took excessive risks because they knew they would get paid whether or not their bets paid off in the long run. The Senate bill contains important corporate governance provisions that would address this problem. For example, the bill requires firms to "claw-back" ill-gotten executive pay, provides shareholders with an advisory vote on executive pay; prohibits bank holding companies from paying employees excessively or in a manner that leads to material financial losses; and grants shareholder access to the ballot to nominate directors.

Other issues: The Senate is also addressing other problems at the heart of the financial crisis through the bill or anticipated amendments, including: auditing the Federal Reserve (Sanders Amendments); "skin in the game" in securitization; off-balance-sheet accounting (Menendez amendment); securitization conflicts of interest (Merkley-Levin amendment); and credit ratings agency conflicts of interest (forthcoming amendment). The bill would also do well to set time limits (say five years) for "too big to fail" institutions to transform their operations and business models into forms that cannot threaten the stability of the whole financial system when they fail.

It has been two years since the collapse of Bear Stearns. Congress held 79 hearings before this bill was introduced, and has held even more in the months that it has been negotiated and amended in committee. The status quo still leaves us vulnerable to another financial collapse. The bill is not perfect, but it can still be amended and the need for progress is urgent.

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