I've got an idea, how about we use our deposits to make loans to households and businesses?

The American Banker warns that as currently written the "Volcker rule" embedded in the Dodd-Frank bill will eliminate a major source of bank profits.

If the latest version of financial reform becomes law as expected, banks would lose a lucrative but wildly unpredictable source of profits scaling back so-called alternative investments over the next several years.

It's a bad time to curb what banks can invest in private equity and hedge funds in compliance with the Volcker Rule, observers say.

Private investing earnings are rebounding after plummeting last year; banks need every scrap of income in a post-recession regulatory and economic environment toxic to profit growth.

Financial regulation is taking all the fun out of banking, apparently. No more can banks invest in hedge funds, trade in unregulated over-the-counter derivatives markets, gouge their customers with exotic mortgage contracts and hidden credit card fees. Gosh, what else could banks sitting on roughly $1.5 trillion of excess reserves possibly do to increase their profit margins?

The politics of financial reform

I'm having a hard time figuring out Congress' motivations regarding financial reform. While Congress worked on health reform my political science colleague and I discussed the infuriating behavior of "moderate" Democrats in light of two competing theories of Congressional behavior. One theory holds that our representatives in Congress are intensely concerned with appealing to the median voter in their districts. They will not act on principle if doing so leaves them even minutely vulnerable to defeat in a primary or general election. Thus Ben Nelson, Blanche Lincoln and the like dug in their heals against the public option and other key parts of the reform package because their constituents opposed these provisions. An alternative theory is that our Congressional representatives seek to retain their seats in a less direct manner. Their goal is to maximize campaign donations, ordinarily from special interests of one kind or another, in order to build up a campaign war chest that will ensure victory and/or discourage viable opponents from running. Thus Max Baucus' goal in negotiating with the Republicans on the Senate Finance committee in the summer of 2009 was not to reach bipartisan agreement on a bill, but to string negotiations along as long as possible in order to squeeze campaign contributions out of the health care lobbies. Ben Nelson was responding to the interests of Mutual of Omaha, not the median Nebraska voter.

Now comes financial reform. At the end of 2009 the House of Representatives, typically, passed a fairly aggressive reform package. The Senate's job, it seems, is to water consequential bills down to the point of being completely toothless. In this case, however, the Senate passed a bill that in some respects (the Volcker rule, treatment of derivatives) was harsher than the bill that passed the House. The conference committee, remarkably, seems to be forgoing opportunities to weaken the bill. And here is the puzzle. Bank lobbies are pouring billions of dollars into this process. According to theory number two, members of the conference committee ought to be weakening provisions right and left. Perhaps they don't because they are concerned about the likely reaction to a weakening of financial reform by the median voter in their districts - that's theory number one. But look at the issues they are debating: how much authority should the Federal Reserve have to regulate interchange rates on debit cards? Should banks be required to spin off their swaps units or can these be operated as separately capitalized subsidiaries within the same bank holding company? Can banks continue to count trust-preferred securities as Tier I capital? It's safe to say that the median voter in any Congressional district has absolutely no understanding of any of these issues, which in theory gives the conference committee members leeway to make concessions to the banking industry while claiming to their constituents that they are putting the screws to them. This seems to be happening to some extent, but by and large the provisions that are most costly to the banking industry continue to be part of the legislation. The article linked to above quotes a banking industry analyst as saying:

“Even if Congress moderates some of these provisions, they are going to be onerous,” said Jaret Seiberg, an analyst with Washington Research Group, a division of Concept Capital. “We continue to believe on issues like interchange and derivatives that the movement will be toward the banks, even though it will be hard to describe any of this as a real victory. It just won’t be as brutal a defeat.”

So what explains Congressional behavior in this case? It's quite a mystery. It can't be that our Congressmen are acting according to principle, can it?

Financial reform

David Leonhardt has some sensible comments on how to strengthen the financial reform bill. Financial reform is a rare example of legislation being improved as it passes through the Senate. As further evidence that the Senate liberals are serious about reform, the American Banker has a story headlined: Democrats Reg-Reform Conference Choices Bode Ill for Banks. Senate Democrats on the committee include Tom Harkin, Chris Dodd, Patrick Leahy, Tim Johnson, Blanche Lincoln, Chuck Schumer, and Jack Reed. Harkin, Dodd, Leahy, and maybe Schumer provide some real liberal firepower. But a bill is not expected to reach President Obama until July 4. That gives banks an awful lot of time to do some damage.

Ross Levine on the causes of the financial crisis

Ross Levine, "An Autopsy of the U.S. Financial System," NBER Working Paper No. 15956, 2010.

The evidence indicates that senior policymakers repeatedly designed, implemented, and maintained policies that destabilized the global financial system in the decade before the crisis. The policies incentivized financial institutions to engage in activities that generated enormous short-run profits but dramatically increased long-run fragility. Moreover, the evidence suggests that the regulatory agencies were aware of the consequences of their policies and yet chose not to modify those policies. On the whole, these policy decisions reflect neither a lack of information nor an absence of regulatory power. They represent the selection -- and most importantly the maintenance -- of policies that increased financial fragility. The crisis did not just happen to policymakers.

Since technical glitches, regulatory gaps, and insufficient regulatory power played only a partial role in fostering the crisis, reforms that rectify these conditions represent only a partial and thus incomplete step in establishing a stable financial system that promotes growth and expands economic opportunities. The entire system of financial regulation -- the system associated with evaluating, reforming, and implementing financial policies – played a key role in the crisis.

Levine focuses on regulatory failures with regard to the rating agencies, credit default swaps, over-the-counter derivatives trading, capital requirements at investment banks, and Fannie Mae and Freddie Mac. The message is that regulators had the tools they needed to prevent the financial bubble that ultimately collapsed, but chose not to use them. Giving new powers to the regulatory agencies, therefore, is not necessarily a solution to the problem. True enough, but the granting of new powers sends a powerful signal to the regulatory agencies about what is expected of them. They got a very clear signal during the Clinton and Bush years that they were expected to exercise their regulatory powers with a light touch if at all; the financial reform bill working its way toward the president's desk gives them a clear message in the other direction. Also, certain reforms in the bill (e.g. the reform of the rating agencies' relationship with securities issuers) directly correct problems that Levine highlights in his paper.

Financial reform

I don't know much about the Senate financial reform bill, but others do. Here's Edmund Andrews and here's Paul Krugman.

One criticism from the left is that the bill leaves too many of the specifics to the discretion of regulatory agencies and doesn't hardwire enough into law. I disagree: there are a million ways that regulations can have unintended consequences or that banks can find loopholes to circumvent them (wait, can you circumvent through a loophole)? I'd rather let the regulatory agencies that have the expertise craft specific regulations within a broad framework set by Congress. Of course that means we need to elect governments that will appoint good regulators and keep a watchful eye on what they're doing, but that's kind of unavoidable in a democracy.

Holy honey pot!

The Senate passed an amendment to the financial reform bill that eliminates the $50 billion fund to pre-finance dissolution of failing financial companies. According to the NY Times:

Mr. Shelby’s amendment eliminated a $50 billion fund that was designed to help bridge financial shortfalls while a failing company was undergoing liquidation. Mr. Shelby said the fund was “a honey pot” that would facilitate “backdoor bailouts.”

Mr. Dodd, who vigorously denied that the fund was a bailout authority, said he had “no objection” to dropping the provision “because whether they pay in advance or after the fact, these costs will be paid by Wall Street and not taxpayers.”

The Shelby amendment also requires the Federal Deposit Insurance Corporation to oversee the liquidation of a systemically important financial company that is failing, using money provided by a special line of credit with the Treasury.

A "special line of credit" with the Treasury seems to me like the mother of all honey pots.

Bailout bill?

Philip Swagel argues that the Dodd bill on financial reform that is working its way toward a vote gives the government the authority to bail out failing financial institutions, thus guaranteeing risky behavior, failures, and future bailouts.

President Obama’s approach, as embodied in Democratic Senator Chris Dodd’s bill, is for discretion and thus for bailouts. Top administration officials state that they will impose losses on counterparties such as lenders to a failing firm. The reality, however, is that the Senate bill gives the government discretion, without a vote of Congress, to put money into a failing firm to pay off creditors. Shareholders will take losses but creditors can benefit from government-provided funds. Regardless of the administration’s intentions, markets participants will understand that the Senate financial regulation bill allows for bailouts, and this will give rise to riskier behavior that in turn makes future bailouts more likely...

A better approach would be a resolution regime centered on bankruptcy. It would impose substantial constraints on the ability of the government to put money into a failing firm. A judge would divide up a failing firm’s resources among its creditors and leave no possibility of a bailout without a vote of Congress. The Federal Reserve could still use its emergency powers under the so-called Section 13-3 authority to lend against good collateral. Enforcing the requirement for collateralized lending ensures that taxpayers are not propping up a failing firm or providing extra payments—bailouts—to creditors (or auto unions)...

here are also middle grounds between bankruptcy and bailout that would considerably improve on the current House and Senate bills. Non-bank resolution authority could be constrained to allow the executive branch to provide only well-collateralized lending to a failing firm and not unlimited discretion as in the Dodd proposal. This would shift emergency lending authority for non-bank firms from the Federal Reserve to the Treasury Department. Such emergency lending could be further constrained by having any lending start a 30-day clock for Congress to approve the action. Failing congressional approval, the intervention would be unwound and the federal lending repaid without a loss to taxpayers (because it would be well-collateralized). A further constraint would be a tripwire that government lending in excess of $50 billion requires an immediate vote of Congress. Together these provisions would give considerable certainty that there would not be unlimited bailouts, while providing the Treasury Secretary with the additional tool to address a crisis.

Ideally we would set up a resolution system that guaranteed that shareholders and creditors took a substantial hit when a financial institution went bankrupt while allowing the government to close the firm and settle its accounts quickly. As Swagel argues, the Dodd bill can be criticized for failing to guarantee pain upfront to the company's stakeholders. Swagel's suggestions, however, seem to involve putting more sand in the wheels of resolution than is advisable. I don't think you can let a situation like the failure of Lehman Brothers or AIG to stay in limbo for weeks or months - in a crisis, the government needs to be able to act quickly and provide some certainty to markets about where the losses are going to be imposed. Because a systemic crisis potentially has such horrific effects for the economy (see 2008, obviously), no promise not to intervene quickly is credible. Suppose we changed the bill along the lines Swagel proposes. What is to stop Congress from passing a bailout bill overriding the law in order to prevent economic armageddon as it did in 2008? We need to recognize that in the case of institutions that are "too big to fail," when push comes to shove there will be bailouts. The best we can do is to regulate and break up financial institutions so that firms that are too big to fail can't take excessive risks, and firms that take excessive risks are not too big to fail.