Bottom-up Financial Reform

The financial reform bill recently signed by President Obama will attempt to attack numerous regulatory gaps and enforce new consumer protections to prevent the next global economic crisis.

But consider this thought from historian Niall Ferguson in his book "The Ascent of Money" (which, by the way, was written before the worst of the financial crisis hit):

"Politicians, central bankers and businessmen regularly lament the extent of public ignorance about money, and with good reason. A society that expects most individuals to take responsibility for the management of their own expenditure and income after tax, that expects most adults to own their own homes and that leaves it to the individual to determine how much to save for retirement and whether or not to take out health insurance, is surely storing up trouble for the future by leaving its citizens so ill-equipped to make wise financial decisions."

The financial institutions who duped unassuming home buyers into taking on mortgages they couldn't afford and the regulators who failed to identify the risks of doing so are certainly to share the blame for the recent economic turmoil. But a major missing piece in the recent regulatory reform bill, and in the general conversation about righting the economy, is an effort to improve basic financial and economics education - something that should be part of every primary high school and college curriculum. For most Americans, this education once came in the home, with parents teaching children about saving money, living within one's means, earning before spending.

But the expansion of credit over the last two generations has complicated this message: Spend, so long as you can pay the interest. Living beyond one's means is now possible - indeed a miracle of credit - but has created a sort of financial overconfidence in society.

In the principal-agent failure that took place in the recent crisis, the "principals" (bankers, etc.) with access and financial sophistication far above that of the average person were able to manipulate finance to make enormous profits, all the while knowingly risking stability of the financial system that enabled such tactics.

The new reforms notwithstanding, it is difficult to assume these mistakes won't happen again when the "agents" in society, ranging from local police pensions funds to average Joes, continue to be ignorant of the rapidly evolving world of finance.

Financial System Reform in the U.S.: What Happens Next

Columbia University's Committee on Global Thought yesterday hosted a lecture with two movers-and-shakers, past and present, in the world of financial regulation in the United States: former Securities and Exchange Commission Chairman Arthur Levitt, and current Commodity Futures Trading Commission chief Gary Gensler. The topic: how to reform a regulatory system that fell asleep at the wheel and failed to detect a crisis.

The panel discussion - chaired by Nobel laureate Joseph Stiglitz - came to two key conclusions: financial markets need more transparency, and the United States needs to take the lead in developing smart regulations if the rest of the world is to sign on.

Gensler's proposal is to bring more futures/derivatives trading into a central clearinghouse, allowing regulators to more easily monitor and assess risk in a market that is fragmented. Centralizing derivatives transactions into a more open, central clearinghouse will cut into the premiums earned by derivatives dealers but will also make the market less risky and more transparent, he contends.

Levitt, a veteran of the Clinton Administration, was decidedly pessimistic on the financial reforms proposed both in the U.S. House and Senate, saying they would do little to prevent moral hazard and a "too big to fail" mentality among major financial institutions. He also said Europe, the United Kingdom and other major financial centers will fail to tighten their regulations until the United States takes the lead. Gensler agreed, but admitted that after 18 years on Wall Street, he knows bankers will, in such a case, take advantage of the inevitable opportunity for regulatory arbitrage - that is, investors will put their money in jurisdictions where capital is less tightly regulated at the expense of American financial markets. These points illustrate that any kind of real policy coordination between the United States and the European Economic Community is an idealistic, rather than realistic, endeavor in such tight political and economic conditions.

What the panel failed to accomplish was finding a way to navigate through the alphabet soup of agencies that are already charged with regulating various segments of the American financial system. Very little was said about the Federal Reserve System, which despite being charged with regulating the banking system from a macroeconomic view, is widely criticized for failing to regulate and for creating the conditions that enabled the crisis through its loose monetary policy. And yet, the Fed remains a key player in any regulatory structure going forward and needs to be a keystone of any reform.

In the end, the discussion itself and the very presence of two speakers representing regulators that, in the grand scheme, have a small purview over the American financial system, revealed how broad a reform is needed. As such, is any discussion that contains only the SEC and CFTC even relevant?

The SEC, staffed with just 3,700 regulators, for example, has very little authority over financial instruments that fall outside the more traditional definition. And, how does an agency such as the SEC both target run-of-the-mill insider trading and securities fraud while also tracking systemic risk in a complex financial system? The failure to bring down Bernard Madoff before it was too late shows how overextended the agency already is.

In the meantime, as Gensler aptly pointed out, the CFTC only regulates futures markets, missing the important and growing piece that is over-the-counter derivatives, among which are the many mortgage-backed securities that were at the heart of the sub-prime crisis. The two in combination have little effect on monitoring a financial system that is increasingly global and increasingly spread over a variety of financial instruments.