There will be much talk in London about global financial regulation, particularly from the Europeans. But don’t count on it ever coming into existence.
At a House Financial Services Committee on March 26 Treasury Secretary Geithner testified that this particular subject “will be at the center of the agenda at the upcoming Leaders’ Summit of the G-20 in London on April 2.”
Secretary Geithner presented a 61 page proposal dealing with financial companies that pose systemic risk. Let me paraphrase the main points:
- Create a Uni-regulator – This idea has been around a while; it won’t hurt. We tried to do this in the U.S. during the last round of sweeping financial reforms but couldn’t make it happen, primarily due to protectionist politics among the existing regulators (SEC, FRB, Treasury, FDIC, etc.). The UK and others have done it. It didn’t prevent the financial crisis from reaching them. Still, it wouldn’t hurt to have at least one adult in charge of the financial markets when things get messy.
- Make companies hold more cash to back up their riskier investments – The banks already have strict national and international capital requirements. It didn’t prevent them from needing a bailout, but the big banks are still standing while the rest of the financial companies are gone. This is probably a good idea.
- Set size limits on unregistered fund managers – I don’t think there should be any size limits: if you provide financial services you should register. Don’t plumbers have to be licensed? Why not bankers?
- Figure out how to regulate derivatives – We’ve known for a long time that this was a problem. If they haven’t figured it out by now, it’s unlikely they’ll get it right; the proposal is short on details. Geithner’s plan is to bring derivatives into the same centralized system now used for stocks and bonds – consolidating the risk rather than dispersing it – definitely a bad idea. The existing U.S. centralized system has, as of December 31, 2007, only $4.9 billion to back up $5.8 billion in off-balance-sheet obligations.
- Have the SEC set requirements for money market fund risk management – I’m not sure why on earth anyone would want the SEC to assume this responsibility. The SEC has failed miserably at protecting investors from basic short selling schemes and even more blatant schemes like Madoff’s Ponzi. Risk management at financial institutions should be the job of the central bank – that means the Federal Reserve, not the SEC.
- Let the government nationalize “too big to fail” companies – They just did this with AIG. In essence, the proposed legislation would codify and make permanent authority for the government to lather, rinse and repeat. Government ownership of financial institutions inevitably leads to inefficiency and worse.
We’ve tried creating “revolutionary” financial laws before: the Depository Institutions Deregulation and Monetary Control Act of 1980 set the stage for the Savings and Loan Crisis; the Financial Services Modernization Act of 1999 helped get us where we are now. Better laws come about in “evolutionary” ways. It starts with a generally accepted good business practice, which all market participants follow. Eventually, one or more participants find a way to advance their position by cheating, by not following that good practice. When they get caught, new laws are created to codify the original “good business practice” and some punishment is put in place for those who don’t. What was once considered just a good way to conduct business now becomes a legal business requirement.
Geithner’s proposed legislation is law by revolution – an attempt to toss aside all previous practices. The legislation was drafted at Davis, Polk & Wardwell, the New York lawyers for the Federal Reserve Bank and advisors to Fed and Treasury on AIG, not the kind of experience I’d want on my resume this year. There is an embedded comment on page four in the pdf-document: “Can Congress write a federal statute trumping a State Constitution?” I’m not sure what frightens me more: that they want to take power away from the states or that they don’t know if they can get away with it! Now is the time to give more authority to the states, not less. By their own admission, federal authorities have proven themselves incapable of protecting investors: Treasury Secretary Geithner told the House, “our system failed in basic fundamental ways.”
Worse yet is the idea of proposing a global financial regulator, which will be high on the agenda at the G-20 Leaders’ Summit. Designing one regulatory framework for financial services to serve the capital markets in every country is akin to looking for people in every country to “cheat” the same way. Capital markets can work anywhere in the world, but the social and cultural foundations of the system that supports these markets may be quite different. The laws and regulations will need to be quite different, too. When it comes to developing the financial institutions that provide the infrastructure for robust capital markets, there is no “one size fits all”.
“Stable financial markets through reform” has been the theme of innumerable conferences, conventions and meetings of the leaders and finance ministers of country groups from G8 to the United Nations. Two decades of experience with the “Washington Consensus” tells us that global regulation will not work any better than concentrating all power in Washington.
Here’s the primary problem with trying to design one set of financial reforms that will serve many nations: Financial services are global not multi-national. Most other products and services sold around the world are multinational, but not global. For example, salt is a multinational product. The salt sold in Cairo is basically the same product as salt sold in Paris or London. Perhaps the label contains the word “salt” in a different language; maybe the Danes use more salt than the Swedes and the Japanese combine it with sugar. But a package of salt contains the same product and is used for the same purpose – one product, used the same way in many nations.
Financial services are different. A share of stock in Paris has different rights, a different meaning, than a share of stock issued in Buenos Aries. Bondholders play a prominent role in restructuring companies in bankruptcy in the US; in France, debtors are protected from bondholders completely. Yet anyone anywhere can buy a share of a French company or the bond of a US company – many products, used for different investments in one world. For reasons like this, there is no one solution for regulating the banks, brokers and stock exchanges in every country.
Economists have known for a long time that global financial regulation – or even ”sweeping” national changes – won’t work. Perhaps the lesson from the current financial crisis will be that national regulation must be supplemented with more oversight in the States. Given Geithner’s plan and his penchant for ever more consolidation of authority over financial services, it’s unlikely we’ll get the chance to find out.
Susanne Trimbath, Ph.D. is CEO and Chief Economist of STP Advisory Services. Her training in finance and economics began with editing briefing documents for the Economic Research Department of the Federal Reserve Bank of San Francisco. She worked in operations at depository trust and clearing corporations in San Francisco and New York, including Depository Trust Company, a subsidiary of DTCC; formerly, she was a Senior Research Economist studying capital markets at the Milken Institute. Her PhD in economics is from New York University. In addition to teaching economics and finance at New York University and University of Southern California (Marshall School of Business), Trimbath is co-author of Beyond Junk Bonds: Expanding High Yield Markets.