Financial Crisis I

An effective manner to explain the financial crisis of 2007-08 may be to look at what is needed from financial reform legislation in order to prevent another financial crisis.

In that spirit, based on readings (and podcasts) including such experts as Dean Baker, Krugman, Nomi Prins, Robert Kutner, Robert Scheer and many others, LSW offers this list of necessary financial reforms. LSW wishes to make explicit that since this list is a result of LSW digesting comments from these various experts, none of these points should necessarily be attributed to a specific expert, all of whom may not agree with LSW or each other.

Nonetheless, a provisional explanation of the causes of the financial crisis as reflected through necessary financial reforms:

  • Limit the size of banks, break up the big banks. When they are so big, they are important enough to the functioning of the economy that the government sees itself forced to step in and bail them out, which creases what is known as ‘moral hazard’, meaning that the big banks will engage in even fiscally riskier practices knowing they will be bailed out. And their very size increases their ability to influence political processes.
    The Baselinescenario says

    “These banks are so powerful that they can confront and defy the government, as seen in the twists and turns of the S.E.C. versus Goldman Sachs case. They are also powerful enough to threaten a form of extortion: If reform is tough, according to JPMorgan Chase’s chief, Jamie Dimon, credit will contract, the recovery will slow and unemployment will stay high. Given the size of his bank, that’s a credible threat.”

    An amendment to restrict the size and leverage of banks was defeated in the Senate on May 6, 2010. OpenCongress Blog writes

    “The amendment, a version of the SAFE Banking Act sponsored by Sens. Sherrod Brown [D, OH] and Ted Kaufman [D, DE], would have placed strict size caps on banks and non-bank financial companies. In practical terms, it would have forced the breaking up of some of the Wall Street corporations. Instead of consolidating like they have been doing for the past 20 years, banks like Bank of America and Chase would have been forced to sell some of their branches off to smaller regional banks over a period of three years.

    Despite a developing narrative that the banks’ own practices have resulted in so much outcry and criticism that the Congress will be forced to impose legislative limits on their size and practices, it would seem, if defeat of SAFE legislation is indicative, that we can conclude at this point Banks 1, Citizens 0.

  • Legislate a new form of Glass Steagal, to separate commercial banking institutions (who work with deposits and checking and saving accounts) from investment banks, those engaged in speculation and investment. Glass-Steagal was passed in 1933 as a way of preventing a recurrence of the events that led to the Great Depression. It helped preserve commercial banking, which had collapsed in early 1933, from the risk oriented investment banks. The Act also originated the FDIC, insurance on bank deposits.Glass-Steagal was repealed in 1999 and signed by President Bill Clinton.

    Many people are calling for new legislation along the lines Glass-Steagal. It should be noted that a case can be made that the separation between commercial and investment banking had been fading long before Glass-Steagal was repealed, due to a need to raise money in competitive securities markets.

    There is also the issue of shadow banking, institutions that carry out banking functions but are unregulated and operate with protection from the FDIC. These need to be regulated, as shadow banking has become huge.

 

  • Regulate the use of derivatives, make them transparent, place their trade in an open market place such as the existing stock exchanges. Derivatives are usually used to manage risk but they were abused by investment houses to simply place bets which amplified the financial crisis. Reformers hope to limit their trading to exchanges and place capital and margin requirements on their trade. Sen. Blanche Lincoln of Arkansas has introduced legislation which incorporates these provisions but is facing opposition by certain Democrats.

 

In addition the proposed legislation has certain faults.

And Nomi Price writes

” It won’t change the nature, transparency, size, complexity or usage of the most heinous derivatives. Why? Because the derivatives that are not standardized or over-the-counter (OTC) will not be required to be traded on regulated exchanges, though they may have to show up on trading depositories (private entities, whose boards are comprised of bankers).”

  • Regulate CDOs and CDSs which as far as I can see, serve no function other than to allow very rich people get richer by gambling with the taxpayers’ money who when the whole artifice collapse rescue these crooks. Sorry about the use of the term ‘crooks’ but what else do you call people who steal other people’s money?
  • Legislate the amount of legal leverage that a bank can employ. In general banks were leveraged on average around 30%. As this shows legislation on leverage was included in the SAFE legislation which has been voted down.

 

  • Legislate the system of compensation which ties salaries and bonuses to enormous profits and fees based on gambling with other people’s money.

 

 

  • Legislate the use of credit ranking agencies in order to remove conflicts of interest, such that a company receiving a credit ranking does not pay the credit ranking agency (which obviously leads to the company buying the credit ranking to choose the agency which provides the highest credit worthy ranking).In essence the credit ratings system as it is now construed allows a bank to buy the credit rating that best suits it. Which results in the system being rotten. Investors can in no way depend on the credit rating of an object of investment.

 

Nomi Prins in the same artice referred to above, writes:

“It won’t remove the conflicts of interest between banks that issue securities and rating agencies that rate them, and get paid a fee for doing so. Rather than nationalizing the rating process for these unconstrained securitized deals, it would create a new entity (Office of Credit Ratings) within the SEC to examine rating agency practices and methodology annually and at some point in the future, issue rules to keep sales and marketing considerations from influencing ratings, leaving a lot of exemption room. The SEC had authority to regulating the rating agencies before the collapse, and it didn’t exercise it.”

While the issue of credit ratings is obviously important LSW has seen little written on the topic in reference to proposed or pending legislation, other than what Prins writes here.

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While not a position held by the sources for this iest, LSW can see little of worth produced by the present U.S. financial services industry. As far as the contention that ‘they’ produce needed financial innovation goes, Paul Volker said something to the effect that the last piece of financial innovation that was beneficial was the introduction of the ATM. Otherwise it would seem that what we have are very rich boys gambling with other people’s money without fear of being held responsible.

This may not be fixed before money is removed from the American electoral system.

Jan. 2011 – From a LSW post

Will Obama shoot down his own financial and health reforms by underfunding the agencies responsible for writing and implementing the new regulations required by the health care reform and financial reform legislation if the federal budget is held to today’s levels as seemingly required by Obama’s call for a five-year federal spending freeze? Definitely worth following.