US financial reform: two key mistakes
Introduction
Two financial reform bills, one passed by the House of Representatives in December, the other currently making its way through the Senate, are touted as representative of the largest overhaul of the financial services industry in recent years. Many economists, politicians and commentators agree that a key problem in the US government’s reaction to the financial crisis was a fundamental incentive problem, where large financial institutions such as AIG and Citigroup where effectively marked as ‘Too Big to Fail’, impliying the possibility of bailouts and thus distorting the market behaviour of such behemoths. It is not clear, however, that the legislation does anywhere near enough to remedy this crucial economic issue at the heart of the recent crisis. In fact, it has been argued that the Senate bill is likely to make this issue worse.
The increased regulation of alternative investments, such as hedge funds and private equity dealers, is another element of the proposed reforms that has provoked controversy. It has been argued that the dynamic nature of the trading strategies and mobility of hedge funds, as well as the increased market efficiency and liquidity promoted by hedge funds and private equity dealers makes increased regulation both futile and potentially harmful.
The actual bills are each over a thousand pages long, the House bill can be found here, and the Senate bill here. Alternatively, read the summary of the Senate bill here and an even briefer summary of both bills here.
A Bailout Bill?
The authors of both bills claim to have ended the era of ‘Too Big to Fail’ (1,2) banks, thus precluding the possibility of taxpayer-funded bailouts. However, the actual mechanisms of reform may have far less effect than is supposed in the summary. The House bill establishes two main ways to deal with the problem, neither of which is adequate. First, a Financial Services Oversight Council is proposed (3), an inter-agency body that aims to enhance the oversight of large financial firms posing a systemic risk to the wider economy. Second, a Dissolution Authority (4) will be established, finding ways to dismantle failing firms safely, apparently without cost to the taxpayer.
Both agencies are reactions to the development of large, systemically risky firms, but when an institution gets to the size of AIG or Citigroup, it is already too late. What is needed is not more bureaucracy, ‘acting after the fact’ of the development of such systemic risk, but real market competitiveness to limit the growth of systemically risky firms. The Senate bill proposes a similarly flimsy solution. Recommendations are to be made to the Federal Reserve for “for increasingly strict rules for capital, leverage, liquidity and risk management”(5). However, the Fed’s judgment on such matters is highly suspect given the enormous leveraged positions built up by some banks previously. Also, it could be argued that it is not any specific type of risk that is the issue here, but the sheer market share and size of some banks. Such requirements also, are notoriously subject to manipulation and trickery.
Such recommendations aim to discourage the growth of some financial institutions, arguably ineffectively so, but fail to address the problem of the large ‘Too Big to Fail’ firms in existence. It has been argued that the bill’s provisions to deal with the failure of such firms actually enshrine the possibility of taxpayer-funded bailouts (6). The Senate bill creates a ‘liquidation fund’ of $50 billion, the cost of which is funded by a loosely defined tax on the ‘largest firms’ (7). This fund goes towards any future liquidity injections needed if a systemically risky firm fails. Leaving aside the perverse incentives for now, it is highly doubtful that the funds raised by contributions from the largest firms would actually be enough to prevent general taxpayer money from becoming involved.
The amount given to Citigroup alone in liquidity injections was $20 billion, while upwards of $40 billion were lent to AIG, with similar amounts going to other firms. Owing to the interlocking nature of the financial industry, the likelihood is that when one fails, many such large firms will fail, leaving $50 billion clearly inadequate.
The bill hints at this possibility, stating that the FDIC (the body responsible for allocating the liquidity injections) can acquire working capital from the Treasury department (8). Since it seems that the $50 billion will not be enough, this amounts to an implicit government guarantee of the large firms. The Senate Bill effectively enshrines the principle of taxpayer bailouts, explicitly outlining the possibility of Treasury funds being deployed as capital for FDIC liquidity injections. It is indeed a ‘bailout bill.’
It is stated that in the event of Treasury funds being deployed as liquidity, the taxpayer will be “first in line for repayment” (9). This does not guarantee repayment in the short term, nor does it change the fact that government debt may have to rise in order to keep the financial system afloat, with all the associated problems. Perhaps even more worrying, however, is that by effectively guaranteeing a bailout for large firms, an incentive problem remains. Such firms will keep all profits from high performance, but face potentially softer losses as a result of poor performance. This is neither ethically justifiable nor economically efficient. it is certainly not free-market capitalism.
No Commitment to Competitive Markets
In explicitly outlining the possibility of Treasury-funded bailouts of large financial firms, the Senate bill hinders competition, in effect conferring a competitive advantage on the ‘Too Big to Fail’ institutions.
From the perspective of such firms, the prospect of a $50 billion liquidity injection, the cost of which is shared between various firms, and that of a FDIC bailout, effectively funded by the taxpayer, is favourable to the bare bankruptcy laws faced by smaller financial institutions. This creates what may be called a ‘soft budget constraint’ for the largest financial firms, in comparison to the ‘hard budget constraints’ faced by the smallest.
Not only does this actually encourage the growth of behemoths such as Citigroup, posing a systemic risk to the wider economy, but it drastically reduces the competitiveness of smaller firms. Lacking competitiveness in the financial industry, encouraged by such government guarantees, is bad for everyone except workers and shareholders of the largest firms in the short run, and bad for us all in the long run.
The perverse incentives outlined discourage competitive financial markets. Systemic risk is increased when large, ‘Too Big to Fail’ firms have highly correlated trading positions. It is almost futile to regulate such activities, given the number of transactions such firms take part in; the possibility of a bailout reduces the incentive for firms to behave prudently and encourages the growth of highly correlated positions amongst the largest firms. The best way to prohibit the development of such risk is to allow mistakes to be punished; the self-regulating aspect of financial markets can then kick in.
By breaking up the largest institutions, competition in the industry could be immediately increased. This is outlined as a possibility in the Senate bill, but it is advocated “only as a last resort” (10). Reducing the size of some quasi-monopolistic behemoths in the financial sector should actually be the first step taken, reducing overall systemic risk and restoring the sector to something like a functioning market is of crucial importance.
Poorly Aimed Regulation
Both the Senate and House bills are insufficiently sensitive to the dangers of softening the budget constraints of large financial institutions and the resulting decreased market competitiveness. In contrast, the legislators seem over-sensitive to the risk posed by the area of ‘alternative’ investments, specifically hedge funds and private equity. In the Senate bill, plans are laid out to bring hedge fund managers under the title of ‘Investment Advisors’, and to raise the threshold of regulation in order to increase the amount of ‘advisors’ under state supervision by 28% (11).
The danger posed by hedge funds is not as serious as is often claimed, and the benefits of increased liquidity and efficiency in financial markets must not be underestimated. Hedge funds take up so many different positions and, as the name would suggest, often hedge against the possibility of large losses, so that failures are more likely cancel each other out than with the large investment banks, whose positions are often highly correlated. There is also the possibility that hedge funds may actually diminish in importance as markets become more efficient and there is less opportunity to take advantage of pricing anomalies.
In fact, hedge funds fail all the time (12), and have been doing so for over a decade with limited systemic impact. There are exceptions to this rule, for example LTCM in 1999, but the large losses of one hedge fund were actually absorbed fairly well by the banks, among others. It is not clear that increased regulation would have made much difference in this case, since not many – fund managers, investors and regulators included – seem to have comprehended the risks taken on by LTCM. It is difficult to see how regulators would do a better job at assessing the risk taken on by hedge funds than the funds themselves.
It is even more difficult to imagine private equity dealers and hedge funds actually staying put in regions with increased regulation; both are notoriously mobile and could potentially relocate to a more hospitable environment. Increased regulation of this more nimble and adaptive area of the industry is likely to be futile.
In short, no one argues that hedge funds and private equity dealers played an important role in this crisis, and even less so that increased regulation of such institutions would have reduced the risk to the financial sector; tighter regulation would not therefore be a worthwhile investment of time or taxpayer money.
Conclusion
On two key points of reform, both congressional finance bills have got it wrong. The potential for a taxpayer funded bailout remains, as does the associated incentive issues for large ‘Too Big to Fail’ institutions. The Senate bill recognises that taking steps to increase market competition by breaking up the largest firms is the solution, but poses it merely as a last resort. By failing to take such steps immediately, and by enshrining the possibility of future emergency liquidity injections for the ‘Too Big to Fail’ institutions, the bill confers an advantage to the largest financial firms and thus shows no commitment to competitive financial markets.
While the proposed reforms are lacking and too inactive in ensuring competitive markets and breaking up the largest firms, the issue of the regulation of hedge funds and private equity dealers seems to have provoked hyperactivity. Increased regulation of these ‘alternative’ investments is both misguided and largely futile.
Based on the proposed reforms in the two congressional bills, US financial reform is likely to do little in terms of encouraging competition, and risks over-reacting and over-regulating ‘alternative’ investments.
References
- Wall Street Reform and Consumer Protection Act, 2009: page 325, Sec 1601, lines 7-14.
- Restoring American Financial Stability Act, 2010: “ends ‘Too Big to Fail” is part of the long title on the cover page.
- Wall Street Reform and Consumer Protection Act, 2009: page 25, Sec 1001, line 10-12.
- Wall Street Reform and Consumer Protection Act, 2009: page 325, Sec1601, line 5.
- Financial Reform Summary as Filed: page 4, ‘Discouraging Excessive Growth and Complexity:’
- ‘Yes, It’s a Bailout Bill’, Phillip Swagel, The Journal of the American Enterprise Institute, 24/04/10.
- Financial Reform Summary as Filed: page 4, ‘Cost to Financial Firms, Not Taxpayers:’
- Financial Reform Summary as Filed: page 4, ‘Cost to Financial Firms, Not Taxpayers:’
- Financial Reform Summary as Filed: page 4, ‘Cost to Financial Firms, Not Taxpayers:’
- Financial Reform Summary as Filed: page 3, ‘Break Up Large, Complex Companies:’
- Financial Reform Summary as Filed: page 7, ‘Greater State Supervision:’
- According to HFR (Hedge Fund Research), 1400 failed in 2008 alone with limited market impact.