Breaking the Banks

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By Christopher Hayes, The Nation

With healthcare reform passed, the next big legislative battle will be over financial regulation reform. Unlike the Affordable Care Act, which the nation followed from opening to closing credits, financial reform has been running in a largely empty theater. Many reporters and citizens find themselves walking into the show two-thirds of the way through, bewildered by its complexity. But the movie's not over yet, and the ending is undetermined. So it's important for progressives to understand the essential elements of financial reform.

Here's where we are. In December the House passed a comprehensive financial reform bill, crafted mainly by Barney Frank and the Treasury. The bill gets, at best, a B-. There are some strong provisions--an independent consumer protection agency and caps on leverage--and some gaping loopholes, such as exceptions for derivatives that render the new requirements largely moot. Even after Wall Street lobbyists had nibbled and chomped through it in committee, the Financial Services Roundtable and Chamber of Commerce still opposed it, which counts as no small point in its favor. The bill passed with--surprise!--zero Republican votes. In late March, Chris Dodd steered his own version of financial regulation reform out of the Senate Banking Committee. Several months of negotiations with Republicans made the bill weaker than Frank's bill but didn't yield any Republican votes. (Sound familiar?) The bill will now go to the floor, where it can be amended. Since almost none of the bill can qualify for the reconciliation process, passage will almost certainly require at least one Republican defection. In other words, a weakened version of the already watered-down House bill will need to be diluted even further to pass. Here's what to watch for as Republicans and self-described centrists start bringing out the fire hoses.

The Consumer Financial Protection Agency: This independent agency to regulate consumer credit practices is the brainchild of TARP watchdog and Harvard law professor Elizabeth Warren. In her plan, the agency would root out predatory and risky practices, like exploding mortgages with tempting teaser rates, before they spread through the system. A reasonably strong version of CFPA passed in the House (despite the banks' fierce effort to kill it and major loopholes carved out for lenders like auto dealers and pawnbrokers), and a weaker version of it exists in the Dodd bill, where it's been converted into the Consumer Financial Protection Bureau and housed in the Federal Reserve. Even in this weakened form, the CFPA has attracted sustained opposition from industry interests. Indeed, the Chamber of Commerce is running TV ads that darkly (and implausibly) argue that a CFPA will somehow target small businesses. Heather McGhee, who's been following the CFPA closely for Demos, points out that even in the Dodd version the bureau retains broad "rule-writing authority," the crucial power to say which practices are and are not kosher. If that ever goes, the raison d'être for the CFPA goes with it.

Bring Derivatives Into the Light: If there's a single cause of the scale of the financial crisis, it's the derivatives known as credit default swaps. Unlike stocks, credit default swaps were not traded on exchanges, where it's easy to keep track of who's doing business. Once things blew up, no one in the market knew who had purchased insurance and who was doing the insuring; no one knew who owed what to whom. This uncertainty about the solvency of each institution hugely exacerbated the panic in the wake of Lehman Brothers' bankruptcy. The obvious solution is to create an exchange for derivatives, not unlike the stock exchange, where everyone trades in a public manner. The House bill contains such a proposal, but thanks to tenacious lobbying by a variety of financial interests, it is, in the words of one analyst who's been briefing Democratic staffers, "Swiss cheese." The Dodd bill is a good deal better, but the same coalition of interests that weakened the House bill will push for the Dodd bill to be similarly carved up. Without real oversight and regulation of derivatives, many of the bill's other provisions can quite easily be made toothless.

Taking on "Too Big to Fail": This is the area where the legislation on offer is the lamest. The House bill does limit leverage and impose some greater costs on bigger banks, but it has no mechanism to require the biggest banks to downsize. The Dodd bill includes a version of the so-called Volcker rule, which would cap bank size, but it requires a six-month study before implementation, allowing the banks an opportunity to subvert the new regulations. So as things stand now, neither bill is likely to downsize the largest banks significantly. But Senator Sherrod Brown is planning an amendment that would cap banks' total outstanding nondeposit liabilities at 3 percent of GDP, or, in current terms, about $426 billion. Consider that Bank of America's outstanding nondeposit liabilities are currently $1 trillion, and you get a sense of just how much this would alter the landscape--and how much the banks will fight it.

There are two ways of viewing the financial crash. One way is as a technical failure with a technical solution--adjusting the mechanisms of oversight, granting regulators new abilities, making market transactions more transparent and aligning incentives in a more productive fashion. That's largely the view taken by the Obama administration, and it's the logic that suffuses much of the pending legislation. The other way to view the problem is as a fundamentally political one with a singular root cause: the banks have too much power. From this perspective, the most important result of reform would be to reduce that power, something each of the three reforms above would help do.

Progressive critics of the healthcare reform bill like Bernie Sanders and Dennis Kucinich voted for it because they were persuaded that the bill moved things in the right direction and would provide immense relief and security to millions of Americans. With financial regulation, the banks aren't holding 30 million uninsured Americans hostage. And a bill that passes but doesn't reconfigure the political economy of the financial sector stands a good chance of making things worse, allowing Washington and Wall Street to go back to the status quo with a false sense of security that the problem has been solved. At this point, I think the House bill with stronger derivatives language would clear the bar. But throughout the next few months, the most important part of the fight to watch is how the banks react as the legislation develops. If the banks aren't fighting and squealing like hell, you'll know the reform isn't worth the paper it's written on. And if you see the main industry groups actually endorsing the final product, as, say, AHIP and PhRMA did with healthcare reform, then it's time to bring those "kill the bill" chants out of retirement.

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Sorry, I switched off when Barney Frank and Chris Dodd, both with their hands already dirty from the route into the mire that we're in, were mentioned in para 2 as the main architects of the proposed regulatory legislation. How screwed up can Washington get? We'll be lucky if we have a currency system left if these two design the oversight mechanisms.

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Sorry, I switched off when Barney Frank and Chris Dodd, both with their hands already dirty from the route into the mire that we're in, were mentioned in para 2 as the main architects of the proposed regulatory legislation. How screwed up can Washington get? We'll be lucky if we have a currency system left if these two design the oversight mechanisms.

I think you're being too cynical. If there are enough eyeballs on this process of financial reform, we can get meaningful legislation passed. Right now, it's impossible to sever the ties between Washington and K Street, but with enough public scrutiny and transparency, something can be done.

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Since almost none of the bill can qualify for the reconciliation process, passage will almost certainly require at least one Republican defection.

In the aftermath of the last outrageous financial bubble/bust, the dot com saga, Congress also got involved and promised Americans that never again would the scoundrels on Wall St. fleece them as they had. So how did that episode go legislatively?

Well, we had a bipartisan bicameral proposal from Senator Paul Sarbanes (D-MD) and U.S. Representative Michael G. Oxley (R-OH). This, kids, was of course way way back in our distant history when Democrats and Republicans, the House and Senate, could actually sit in the same room with each other and think of policy not just politics.

We'd have to go waaaaaaaay back to 2002 when George Bush was President. And what were the final votes on Sarbanes-Oxley? Well, on July 25, 2002 it passed with a vote of 423 to 3 in the House and 99 to 0 in the Senate. Let me repeat that in case you missed it. Ninety nine US Senators voted for greater financial transparency rules. None voted against it. Today, we're considered lucky if just one single Republican senator is willing to cross the aisle, after a financial rupture easily an order of magnitude bigger than that which led to SOX. Republicans. Gotta love em.

Bring Derivatives Into the Light: If there's a single cause of the scale of the financial crisis, it's the derivatives known as credit default swaps. Unlike stocks, credit default swaps were not traded on exchanges, where it's easy to keep track of who's doing business. Once things blew up, no one in the market knew who had purchased insurance and who was doing the insuring; no one knew who owed what to whom. This uncertainty about the solvency of each institution hugely exacerbated the panic in the wake of Lehman Brothers' bankruptcy. The obvious solution is to create an exchange for derivatives, not unlike the stock exchange, where everyone trades in a public manner. The House bill contains such a proposal, but thanks to tenacious lobbying by a variety of financial interests, it is, in the words of one analyst who's been briefing Democratic staffers, "Swiss cheese." The Dodd bill is a good deal better, but the same coalition of interests that weakened the House bill will push for the Dodd bill to be similarly carved up. Without real oversight and regulation of derivatives, many of the bill's other provisions can quite easily be made toothless.

So, here's my own personal hot button issue. This is the one single thing that I would dearly love to see happen - move the OTC markets to a regulated exchange with centralized clearing so as to remove (or at least mitigate) counterparty credit risk. It's such an absolutely no-brainer, and yet the lobby from Goldman and UBS et al is ferociously set against it happening.

There are technical challenges. Unlike stocks or even standardized futures or options contracts, CDOs and CDSs are not fungible. Each issue is unique, each contains tranches of distinct securities with their own maturities and risk profiles. Having a deep and liquid and efficient market will require some way to trade similar but not identical products against each other. It's a challenge, but it can be done. We do it in the physical commodities markets. And we're even doing it already for CDS. ICE has had a trading CDS market since last year. Paltry volumes, but it certainly proves that the concept can work. CME Group is also now offering clearing services for OTC CDS. Maybe, just maybe, these markets can take off in spite of what looks to be a weak bill from Congress and pressure from the banks.