Public Policy Analysis & Opinion
How big is it?
Too big to regulate means too big
By Kevin P. Hennosy
Finally, after more than 30 years of happy talk and wishful thinking, someone is speaking the truth in Washington D.C.; however, it is not yet clear if anyone is listening.
On July 21, 2009, the House Financial Services Committee conducted a hearing to discuss the concept of how to regulate “systemic risk” to the financial system.
At that hearing, Alice M. Rivlin, Ph.D, an economist with the Brookings Institution and visiting professor at Georgetown University, explained the cause of the world economic crises in one sentence. Professor Rivlin does not have all the answers, but at least she has a clear understanding of questions that policymakers must ask.
“In recent years, anti-regulatory ideology kept the United States from modernizing the rules of the capitalist game in a period of intense financial innovation and allowed perverse incentives to creep in,” opined Professor Rivlin.
Despite her impressive academic credentials from Bryn Mawr and Radcliffe, she is not a fuzzy-thinking theorist. She brings to this discussion a lifetime of real-world experience. She serves on the board of directors of the New York Stock Exchange. She was a Federal Reserve Board Governor, a director of the Office of Management and Budget, and she served on the staff of the Congressional Budget Office.
While most commentators and pundits have focused on the question of when a financial institution becomes “too big to fail,” Dr. Rivlin stresses the need for efficient and effective regulation.
The professor called for expanded powers for the Federal Reserve to monitor and regulate leverage, which financial institutions use to inflate speculative bubbles. She suggested that this means to seek out and address “loopholes and perverse incentives” that weaken the financial system. Finally she rejects the creation of a special regulatory agency with limited jurisdiction over the nation’s largest financial holding companies, which she speculates would only drive the bad behavior down the cordon to shadowy subsidiaries—as occurred with AIG.
The discussions in Washington are difficult to follow because they do not follow traditional lines financial subsectors. If imprudent leaders of both parties had not agreed to repeal Glass-Steagall, the firewalls between banking, securities, and insurance, it still would have been practical to maintain separate and highly tailored regulatory frameworks for each financial sector. The Gramm-Leach-Bliley Act of 1999 put an end to that framework and invited the return of boom-bust economic cycles that punctuated the history of the 19th century in the United States. The repeal was a predictably stupid thing to do, but it is done and it would be highly difficult to restock Pandora’s Box.
If the aim is to avoid failures, which is a laudable aim, the most important question to answer is whether or not a financial institution is too big to regulate. If an institution like AIG grows so large that the regulatory framework cannot provide oversight, then the regulatory framework needs to grow—or through application of antitrust laws, the institution needs to shrink.
Before German reunification, French officials used to argue against the reformation of the colossal power at the center of two world wars. The old saying went, “France does not hate Germany. France loves Germany so much that she believes there should always be two of them.”
When I watched the proceedings of the National Association of Insurance Commissioners (NAIC), I had the same feelings about AIG. I did not hate AIG. I loved AIG so much that I wished the Justice Department Antitrust Division would give us five of them. Now, after the fall of AIG, I am kind of sweet on State Farm in the same way.
Roots of the problem
When George H. W. Bush was his own man and running for president in 1980, he called the Reagan economic plan Voodoo Economics. He was right. Before the elder Bush made the proverbial trip to the crossroads in order to extend his political career, he knew that the twin policies of deregulation and regressive taxation would trash the American economy. It took nearly three decades of the voodoo treatment to bring the world’s strongest economy to its knees, but that is what happened in 2008.
Dating back to Alan Greenspan’s years on President Ford’s Council of Economic Advisors, the United States has pared back, shrunk, and retarded the growth of its regulatory framework while financial institutions have inflated their size through a series of speculative binges.
A cadre of the most talented lobbyists in the world blew the smoke from the fire that Greenspan lit in the 1970s for the next three decades until it wafted through federal and state offices. The sweet and intoxicating byproduct of the slow burn of deregulation obscured the view and judgment of policymakers. Even if financial regulators wanted to operate what was left of the regulatory framework, under the influence of a generation-long clambake, something bad was bound to happen.
Dr. Rivlin’s testimony skillfully rejects the Obama administration’s minimalist approach to re-regulation. “The Obama administration would create a Financial Services Oversight Council (an interagency group with its own staff) to perform this function. I think this responsibility should be lodged at the Fed and supported by a Council,” said Rivlin.
The Obama proposal comes from some of the same people who advised President Clinton to sign the legislation that repealed Glass-Steagall. First among these is Lawrence Summers, who appears to have more interest in driving up bonuses for Wall Street barons than seeing kids go to school, parents go to work, or retirees go to the grocery store.
In true Summers fashion, the proposed FSOC seems designed to eliminate potential jurisdictional turf battles and calm fears among financiers rather than modernize the rules of the capitalist game in a period of intense financial innovation. It seeks to preserve most of the existing regulatory agencies—which preserves existing Iron Triangles.
Iron Triangles consist of regulated entities, regulatory agencies, and congressional oversight committees. The Obama administration clearly wants to avoid conflicts with powerful committee chairs and financial lobbies that have worked hard to master the current balance of power and that do not want to see it disrupted. Call it change within the status quo.
Interagency groups can play a useful role in providing advice because the format preserves the parochial interests of each member agency in the council. However, the lingering parochialism inhibits decisive action in the interest of the overall system.
Dr. Rivlin would assign some new regulatory oversight to the Federal Reserve built on the central bank’s traditional activities. In particular, she proposes that the Fed receive jurisdiction for monitoring and regulating the role of leverage across financial sectors. Furthermore, Dr. Rivlin proposes a new regulatory function that she calls the Macro System Stabilizer, charged with spotting the regulatory gaps and perverse incentives across the financial services sector.
“The case for creating a new role of Macro System Stabilizer is that gaps in regulation and perverse incentives cannot be permanently corrected. Whatever new rules are adopted will become obsolete as financial innovation progresses and market participants find ways around the rules in the pursuit of profit. The Macro System Stabilizer should be constantly searching for gaps, weak links and perverse incentives serious enough to threaten the system. It should make its views public and work with other regulators and Congress to mitigate the problem,” she testified.
In addition to creating an institutional framework charged with identifying and correcting regulatory shortcomings, Dr. Rivlin proposed the creation of a “Bubble Threat Warning System,” within the Fed. “The warnings would be public like hurricane or terrorist threat warnings. When the threat was high—as demonstrated by rapid price increases in an important class of assets, such as land, housing, equities, and other securities without an underlying economic justification—the Fed would raise the threat level from, say, Three to Four or Yellow to Orange. Investors and financial institutions would be required to put in more of their own money or sell assets to meet the requirements. As the threat moderated, the Fed would reduce the warning level.”
What Dr. Rivlin would like to see is a move away from monetary policy as a means of addressing speculative bubbles. Rather than raising interest rates to deflate bubbles, with its inevitable negative impact on job creation and purchasing power, she would rather financial regulators monitor and slow the inflation of bubbles through regulating “leverage.”
Dr. Rivlin continued: “The biggest challenge to restructuring the incentives is: How to avoid excessive leverage that magnified the upswing and turned the downswing into a rout? The aspect of the recent financial extravaganza that made it truly lethal was the over-leveraged superstructure of complex derivatives erected on the shaky foundation of America’s housing prices.”
As we learned in the fall of 2008 and the spring of 2009, these leverage concerns were not limited to the banking subsector. A subsidiary of the AIG holding company had used issued unregulated insurance instruments to transfer the risk of securitized debt. Several large life insurance companies required federal financial relief to cover losses in mortgage backed securities—and many more might have needed the same relief if life insurers were required to report their bond holdings at market value.
Rather than creating a special list of “too big to fail” institutions with a dedicated federal regulator, Dr. Rivlin suggested that it is time “to seriously consider creating a new financial regulator.
“This new institution could be similar to the UK’s FSA, but structured to be more effective than the FSA proved in the current crisis. In the U.S. one might start by creating a new consolidated regulator of all financial holding companies,” she explained. “It should be an independent agency but might report to a board composed of other regulators, similar to the Treasury proposal for a Council for Financial Oversight. As the system evolves, the consolidated regulator might also subsume the functional regulation of nationally chartered banks, the prudential regulation of broker-dealers and nationally chartered insurance companies.”
Who, me? A regulator?
The discussion of a new federal regulator with jurisdiction over all financial holding companies deserves attention. In the post Gramm-Leach-Bliley world, most of the old regulatory divisions make little practical sense and serve only to preserve outdated parochial viewpoints.
For example, the Fed has a corporate culture that eschews seeing its duty in regulatory terms. At his confirmation hearings to become Treasury secretary, Chairman Timothy Geithner actually said that he had never been a regulator. That is a rather odd perspective for the former chair of the New York Federal Reserve Bank to hold, but it reflects a dangerously collegial corporate culture at the Fed.
In insurance, we have regulatory authorities led by people who refuse to believe that they were not appointed to lead the Department of Development. And when insurance holding companies like AIG go terribly wrong, they sit in front of Congress with a straight face and testify that AIG was not an insurance company.
It is interesting that Professor Rivlin specifically mentioned moving regulatory responsibility for nationally chartered banks to a new regulatory agency, which would eliminate the need for the Office of Comptroller of the Currency (OCC). Independent insurance agents and consumer advocates have battled the OCC for decades as it sought to preempt state-based consumer protections. The OCC staff even refuses to use the term “regulate” in connection with its role. (The comptroller’s staff prefers the term bank “supervisors”—a creepily voyeuristic identification reminiscent of the Chauncey Gardner character in “Being There,” who “liked to watch.”)
The financial sector needs affirmative and efficient regulation, and not just a collection of bureaucrats who like to watch.
Professor Rivlin’s testimony is available at: www.house.gov/apps/list/hearing/financialsvcs_dem/rivlin_testimony.pdf
Kevin P. Hennosy specializes in the history and politics of insurance regulation. He began his insurance career in the regulatory compliance office of Nationwide Insurance Cos. and then served as public affairs manager for the National Association of Insurance Commissioners (NAIC). He is currently writing a history of insurance and its regulation in the United States and is an adjunct professor of political science at Avila University.