Monday, September 14, 2009

Thoughts on Financial System Reform and American Leadership

Economic Donkeys, by former IMF chief economist Simon Johnson ("The Quiet Coup") and Peter Boone, head of the Effective Intervention charity, lays out a persuasive case for what should be done with Big Finance. Please read the entire piece. Here are excerpts:

Today, a year after global financial collapse and the ensuing tragedy for millions, our economic leaders are lining us up to suffer again (and again) through the same horrible experiences.

Today Lehman’s senior debt trades at a mere 10 cents on the dollar, suggesting its $600 billion in assets were a mirage. This outcome is even more startling when compared to senior debt at Kazakhstan’s defaulting large banks, where management is now accused of serious malfeasance, yet that debt trades at 20 cents on the dollar – twice the price of Lehman’s debt.

At the G20 meeting of finance ministers last week, political leaders united behind two key steps which they claim will “prevent another Lehman”: tighter controls on the pay of executives and more capital for banks. France and Germany blame the crisis on lax regulation in Anglo-Saxon markets and excessive pay packets that encourage irresponsible risk taking. The British and Americans counter that European banks have too much debt (i.e., in the jargon, are “overly leveraged”), and need to raise more capital. The final communiqué proposes to do both, and we will hear more of the same at the upcoming G20 heads of government summit in Pittsburgh. But, in reality, both sides want only minor adjustments that cannot solve the real problems posed by our financial system.

Tim Geithner, now US Treasury Secretary, is pushing for higher capital requirements for banks, i.e., they need to have more shareholder funds to protect against future losses. But he surely knows that two weeks prior to its bankruptcy, Lehman’s management reported they were well-capitalized, with a tier one capital ratio of 11% — roughly twice what the United States currently considers is needed for a well-capitalized bank, and much higher than the American side is proposing in private conversations.

The pre-crisis activities and portfolios of Barclays, Goldman Sachs, and other “survivors” of this crisis were only slightly different from Lehman Brothers or Bear Stearns, which failed. The “good” banks also securitized subprime assets, helped build the intricate web of IOUs between banks and insurance companies, and leveraged their balance sheets to enormous levels. The winners were not better, they were just smart enough to make sure someone else held the bad assets when the music stopped, and they were powerful enough to win generous bailout packages from their governments.

The danger we face is that, by bailing out these institutions and rewarding failed managers with new powerful positions, we have now created a much more dangerous financial system. The politically well-connected, knowing they will most likely do fine in the next crisis, is now highly incentivized to take even greater risk.

Once we admit this profound problem in our system, we can begin to think of the radical measures needed to solve it. There is no doubt these solutions will include much greater capital requirements, so that bank shareholders know that they face substantial losses if their ventures fail.

But, we also need to ensure that our regulators are not captured by the banks that they are meant to oversee. This means we need to put checks on financial donations to political parties, and we need to buttress our regulators with more intellectual firepower and financial resources, along with rules that ensure independence, in order to be sure they can act in the interests of the broader population.

We also need to close the revolving door, through which politicians and regulators leave office to earn their nest eggs in finance, and “financial experts” move directly from failing banks to designing bailout packages. The conflicts of interest are abundant and most dangerous.

Last week the UK’s chief financial regulator, Adair Turner, faced heavy criticism from the City, Chancellor Darling, Boris Johnson, and editorials in the Financial Times and Wall Street Journal. His main offense was daring to raise the issue of whether parts of our financial system have become socially dysfunctional, in an interview with Prospect Magazine. He called for greater capital requirements at banks, and he pondered how it would be possible for regulators to preserve the valuable parts of our financial system, while ensuring that regulation limited the harmful parts. These are eminently sensible questions which anyone with a public spirit should understand are critical policy issues today.

Sadly, these public rebukes to Lord Turner are a further indication that very few of our leaders are prepared to even discuss the real problem, let alone seek a sufficient solution.

DoctoRx here.

I believe that the United States and the world need personal leadership from President Obama on this issue.

While 30+ million U. S. citizens lack health insurance (millions of whom are eligible for programs such as Medicaid but have not joined) but by law do have access to emergency treatment is an important issue, the current (receding?) economic depression and financial crisis affects us all. Why the overwhelming emphasis on health insurance but not on a risky financial system that has been estimated to have cost $23.7 trillion in direct governmental expenditures and guarantees? (Estimate by Special Inspector General for TARP Barofsky)

Sadly, the President may be "distracted" from financial reform efforts by the effort to aid less than 10% of all Americans in obtaining health insurance. The job is indeed demanding, but he asked for it!

As the Johnson/Boone essay argues, the entire world needs enlightened American leadership to help build a stronger financial and banking system. It needed it from Barack Obama beginning the day he won the election. Nearly one year later, this leadership remains to too great a degree missing in action.

Copyright (C) Long Lake LLC 2009

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