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Financial Reform Rising

The story so far on financial reform is not a pleasant one. Fortunately there is now some movement in the right direction.

Hundreds of activists rallied on K Street in Washington, D.C. on May 17, 2010 in support of financial reform. (Photo: Americans for Financial Reform / Flickr)

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The story so far on financial reform is not a pleasant one. Fortunately and perhaps surprisingly, in part through the efforts of a growing number of people – including Anat Admati and Sheila Bair, recently interviewed on Moyers & Company – there is now some movement in the right direction.

In the early and mid-2000s, US officials allowed large financial institutions to take on big risks – being persuaded that the people running those firms knew what they were doing. In particular, important parts of our financial system became highly leveraged, in the sense that they took out debts that were very large relative to their shareholder equity.

At that time, on average, the world’s largest banks had equity worth only around two percent of their total balance sheets. As asset values went up, so did bonuses – financial executives are typically paid based on their “return on equity,” unadjusted for risk.

When house prices turned down and related losses mounted, these small amounts of shareholder equity – the core of what is known as capital in the banking world – were quickly wiped out for the most highly leveraged firms. And investors began to fear, quite reasonably, that other thinly capitalized firms could become insolvent, hence making it difficult for those firms to raise further funding.

The ultimate government reaction, spearheaded by Tim Geithner (first as president of the Reserve Bank of New York and then as Treasury secretary under President Obama), was to throw its balance sheet behind the financial system – providing what became, effectively, an unconditional guarantee for our largest banks.

The logical next step would have been a set of reforms to prevent big financial firms from ever becoming so highly leveraged again. But people considered “too big to fail” like being able to borrow heavily – they are receiving a large implicit government subsidy that lowers their cost of funding and gives them a big competitive advantage.

Not surprisingly, the big banks and their allies fought back against any reasonable reforms that would limit their leverage and their ability to take big risks. The Dodd-Frank reforms passed by Congress in summer 2010 were, as a result, disappointing.

But a funny thing happened on the way to the next boom-bust cycle. A loose but effective coalition developed, partly to put additional pressure on Congress, but mostly to argue the details of regulation – and particularly the importance of increasing bank equity (and, equivalently, limiting leverage at big banks).

Too Big to Fail and Getting Bigger from on Vimeo.

Anat Admati has been a thought leader in this process – her book with Martin Hellwig, The Bankers’ New Clothes, provides an accessible, persuasive and comprehensive argument in favor of requiring more equity (and relatively less debt) in finance.

Sheila Bair, former head of the Federal Deposit Insurance Corporation (FDIC), argued these points before the crisis (as a lonely voice), during the crisis and reforms (a little less lonely), and now (when she picks up a great deal of support). She created and chairs a Systemic Risk Council that gets considerable access to top officials. (I am a member of that Council.)

On Capitol Hill, Democratic Senators Sherrod Brown, Jeff Merkley and of course Elizabeth Warren are outspoken in favor of more equity for banking (as part of a broader reform package). They are picking up Republican support, including Senator David Vitter.

In civil society, Dennis Kelleher’s Better Markets has been an amazing advocate for sensible reform – not just in banking but for all financial markets, including the most complex derivatives.

And within official circles, Tom Hoenig – former president of the Kansas City Fed and now vice chairman of the FDIC – has been a powerful advocate for more capital. He has allies. Just last week, SEC Commissioner Kara Stein gave an important speech arguing that more and better quality capital – meaning stronger loss absorption capacity – should become a higher priority for securities regulators also.

The latest rules from officials, including the Federal Reserve, are starting to head in the right direction. As Professor Admati points out, there is still a long way to go. But, in part thanks to her efforts, the intellectual argument has been substantially won.

The obstacles that remain are formidable – massive campaign contributions and the exercise of sophisticated political power by the strongest lobby on the face of the earth. But everyone supporting financial reform – focused on greater equity in the financial system, with all that entails and implies – should draw heart from the last few years, and put their backs into working harder.

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