Financial Reform Doesn't Need to be Complicated

In response to Senator Dodd's proposed bill - which uses a lot of buzzwords that sound like reform, but really just maintains the status quo - several writers have forcefully argued that we need to focus on the actual purpose of banking.

As a number of people have pointed out, any bill which is 1,136 pages long will contain loopholes big enough to drive a truck through and more holes than swiss cheese. Almost no one will actually read the bloody thing, those that do will see that it is rife with ambiguities. And it will get so marked up by the time that it works its way through various committees that - by the time it is passed - there will be more hole than swiss cheese.

Unless financial legislation addresses the big picture - why do we have banks and what do we want them to do - nothing will really change.

One blogger sums up the big picture argument pretty succinctly:

I worry though that — despite the healthy impetus and rhetoric [in the Dodd bill] — that the center of thought on all this seems stuck in the same equations, theories, ideas and general zeitgeists about efficiency and all that. Just a bit of big-time tweaking is all we need... But a new coat of paint on a rotting wall will eventually chip and crack.

No, we need to make them really think. Let’s have a “Preamble” to this legislation, like the Bill of Rights is to the Constitution, that sets up the Philosophical ground. What’s a bank for? What’s a financial system for? What is the public good?

I have repeatedly written that Glass-Steagall should be reenacted, and that banks should choose either to act as traditional, safe depository institutions or as speculative funds, but not both. I have also argued that companies which extend credit should be treated like public utilities. But the above-quoted blogger hits the nail on the head with very few words: we need to focus on the overall purpose of the banks and the financial systems.

And fund manager Marshall Auerback provides a detailed proposal for a public purpose test:

We feel that the ‘race to the regulatory bottom’ could easily be solved via a simple mechanism: If you don’t fall in line with our regulatory requirements, you’re simply denied a banking license to operate in this country. Problem solved. The United States is the biggest banking market in the world. Do you think any major bank would willingly vacate this market?

And even if the “too big to fail” behemoths decided to transplant a bunch of their operations elsewhere, the country would still be left with thousands of community banks which could fill the void and better fulfill the public purpose described by Mr Blankfein: namely, to “help companies to grow by helping them to raise capital”, rather than extracting their pound of flesh via grotesquely high financial intermediary fees, as is the case today...

WHO controls the banks is ultimately less important than HOW we control the banks’ activities. Oversight is all very nice, but at times it pays to get back to first principles. What on earth is the public purpose of these things?

Banks are set up and supported by government for the further benefit of the macro economy via providing a payments system and lending in a way that is specifically defined by regulators. Newsflash: the public purpose of banking is NOT to provide profits per se to shareholders. Rather, the provision of the ability to earn profits is only a tool used to support the attendant public purpose. Banks should only be allowed to lend directly to borrowers, and then service and keep those loans on their own balance sheets. There is no further public purpose served by selling loans or other financial assets to third parties, but there are substantial real costs to government in regulating and supervising those activities. There are severe consequences for failure to adequately regulate and supervise those secondary market activities as well.

Banks should be prohibited from engaging in any secondary market activity because it serves no public purpose and may result in severe social costs in the case of regulatory and supervisory lapses. Some argue that these areas might be profitable for the banks, but this is not a reason to extend government sponsored enterprises into those areas. Therefore, banks should not be allowed to buy (or sell) credit default insurance. The public purpose of banking as a public/private partnership is to allow the private sector to price risk, rather than have the public sector pricing risk through publicly owned banks.

If a bank instead relies on credit default insurance, then it is transferring that pricing of risk to a third party, which is counter to the public purpose of the current public/private banking system. Banks should not be allowed to engage in proprietary trading or any profit-making ventures beyond basic lending. If the public sector wants to venture out of banking for some presumed public purpose it can be done through other outlets.

If the activities of the banks are not facilitating the production and movement of real goods and services what public purpose do they serve? It is clear they have made a small number of people fabulously wealthy. It is also clear that they have damaged the prospects for disadvantaged workers in many parts of the world.

It’s more obvious to all of us now that when the system comes unstuck through the complexity of these transactions and the impossibility of correctly pricing risk, the real economies across the globe suffer. The consequences have been devastating in terms of lost employment and income and lost wealth.

All governments should sign an agreement which would make all financial transactions that cannot be shown to facilitate funding for real goods and services illegal. Simple as that. When we keep these principles at the front of the argument, we can see that what Senator Dodd and Congressman Frank are arguing about is akin to how to rearrange the deck chairs on the Titanic.