Monday, June 21, 2010

The Financial Reform Bill balancing act --- off the beam?

The Financial Reform Bill is moving to some sort of conclusion. There will definitely be a bill, and it will be too complex by far and full of loopholes and one-off congressional "mandates". We need financial reform but vexing open issues of importance remain unresolved. Big picture issues are:
---Regulation vs. Elimination --- Congress can pass laws to regulate many financial products. Rather than take responsibility for regulation they can just choose to eliminate certain products or established ways of doing business. Derivatives are the primary example of this but there are others in the consumer bill. Derivatives can be required to be listed on open exchanges, limits can be set on certain derivatives solely used for betting and manipulating, not hedging. Changing the entire practice of derivatives, eliminating bank capabilities, would be disruptive and highly capital inefficient. Just regulate, do your job please.
---Credit Expansion vs. Credit Contraction --- At this crucial point in the supposed recovery, actions that unnecessarily raise capital requirements and restrict risk adjusted pricing would end credit expansion to the small business, middle market, and consumer constituencies. Regulate abuses of the system that led to the '08-'09 crisis but please don't try to level the playing field so much that banks can't afford to lend to firms and individuals that could on average responsibly use the money, with somewhat more risk to the banking system.
---Precision vs. Ambiguity --- Vague language creates uncertainty which creates investor paranoia. In matters of significant consequence the language needs to be precise enough to be dependable long term. That is not the case yet with the so-called "Volcker rule" on proprietary trading. What is proprietary trading as opposed to hedging a loan book, hedging a treasury portfolio, and hedging a foreign exchange book. Who decides. Do new leaders or bureaucrats at the SEC come up with different interpretations with each new appointment, each new administration change. This is an important issue that requires more attention than it is receiving in the big "kitchen sink" bill.
---Innovation vs. Inbred Caution --- Will the complexity and breadth of financial regulation make innovation in financial offerings to both business and consumer markets forbidden territory. Why risk change if sitting still involves less risk and less attention from a Congress and Administration on the hunt for more scapegoats. What encourages firms to differentiate their activities and develop new markets?
---Globalization vs. National Priorities --- The focus on compensation, products, pricing thresholds, and banking structure could set in motion more nation based competition for talent and customers. It brings to mind Smoot Hawley or Hawley Smoot, whatever it's called, that tariff bill passed in 1930. It started out as just a bill to put a tariff on agricultural products to give the struggling farmers a break. Some in Congress proposed tariffs on industrial products as well. By the time the bill was passed all proposals were accepted and there were tariffs on everything. At the time, within a year or two of passing the bill it was widely viewed as exacerbating the Great Depression. Today many economists say that it was of little consequence, monetary policy was the issue. Leave it to economists to theorize away the obvious. On the margin Smoot Hawley was horredous policy, and one should not forget that WWII eventually followed a slowdown in international trade. Today we live in an economy dominated by the service industries of finance, communications, and technology, not agriculture and manufacturing. The Financial Reform Bill could be the 21st century Smoot Hawley and we don't even know it.

Soon we will have a bill and today, as much as constructive financial reform is needed, it is difficult to be optimistic about the final product.


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