Regulatory shake-up: Right ends, wrong means

By Felix Salmon
June 15, 2009

I’m a bigger fan of this morning’s Geithner/Summers op-ed than Simon Johnson is. As a statement of where we want to be it’s a good one; I especially like the way that, by regulating OTC derivatives trades, Geithner and Summers are taking a rather more sensible route than trying to make all derivatives (or all credit derivatives) exchange-traded. I also like the way in which capital requirements for banks will rise with banks’ size — it’s a good incentive to stay small(er), rather than, Lewis/Weill-style, going on massive acquisition rampages.

I do however share Johnson’s disappointment with respect to the “council of regulators with broader coordinating responsibility across the financial system” — we need a powerful single regulator with teeth, not a council of bickering sub-regulators. And if Johnson is right that Geithner and Summers are backing away from the creation of a consumer-facing financial product safety commission, that’s also a bad sign.

And what about “requir[ing] the originator, sponsor or broker of a securitization to retain a financial interest in its performance”? Johnson is unimpressed:

Reality: It was a big unpleasant shock when everyone realized that Lehman, Bear Stearns, and others had retained a large exposure to dubious financial products, some of which they had issued. We are back to the Greenspan fallacy here – if financial firms have an incentive not to screw up on a massive scale, they won’t.

I think the point here is that although the big banks thought they were selling off their credit exposure, largely by selling synthetic CDOs, in point of fact they weren’t: the unfunded super-senior tranches which remained on the banks’ balance sheets were meant to be risk-free but ended up imploding. By contrast, I read the Geithner/Summers proposal as saying that banks will have to obviously retain risk assets on their balance sheets, and account for them — that never really happened before.

The big question, of course, isn’t about the ends — about which we can broadly agree — but rather about the means. Do Geithner and Summers really believe we can achieve all this by tinkering around the edges of the present regulatory system and keeping most of the present regulators in something approaching their current form? I don’t buy it. But I fear that on Wednesday that’s what they’re going to be selling. And that is going to be the real failure.

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