Felix Salmon

Jesse Eisinger has a great column today on the way in which the Fed is failing to embrace its crucially-important role as America’s top bank regulator. The Fed is “the most powerful banking regulator in the world,” he writes, but doesn’t act that way:

In the years before the financial crisis, the Fed was a miserable failure in that role, a creature of the banks, not a watchdog…

Under the giant Dodd-Frank package, the Fed was given an expanded regulatory role. The new consumer financial products regulator is housed within the central bank. The Fed also now officially oversees investment banks, which it had to rescue during the crisis. Congress broadened the Fed’s remit to cover nonfinancial institutions deemed “systemically important.” Congress created a new role, the “vice chairman of supervision,” to raise the prominence and importance of its responsibility. (It remains unfilled.) Perhaps most important, the Federal Reserve is supposed to play a major role in taking over big banks that fail.

Banking supervision has always been something of a backwater at the Fed. Within the institution, the sexy stuff is monetary policy. That’s where most of the resources and attention goes. The chairman and the board spend a disproportionate amount of their time on it, and monetary policy expertise largely dictates the selection of board members. Many question that mind-set.

It’s ridiculous that the job of vice chairman of supervision remains unfilled. Everybody knows the man who can, will, and should do the job: Dan Tarullo. He literally wrote the book on such things, and he’s already on the Fed board — so why the delay?

As Jesse quotes Mike Konczal as saying, “regulation needs accountability and transparency, and the Fed is just not set up to be accountable or transparent.” That needs to change — and the only way that the change is going to happen is if every board member is pushing for it to happen. Especially Ben Bernanke. He hasn’t started doing that yet, which is a bad sign. And even if and when Tarullo gets the bank-supervision job, he’s going to need to have a lot of institutional support in the rest of the organization if he’s going to be effective. So far, there’s precious little indication that he’s going to get it.

I spent most of this morning at SecondMarket, having a long conversation with Adam Oliveri, the person in charge of their private company market. That’s the part of the company which gets the most attention: it’s where stock in companies like Twitter and Facebook change hands, for instance. I learned a huge amount while I was there, and have now changed my mind on whether Facebook is going to go public: I finally understand exactly why companies need to do an IPO once they have more than 500 shareholders.

Once the 500-shareholder limit is breached, companies have to start reporting detailed financial information to the SEC. Which isn’t in and of itself a compelling reason to go public — lots of private companies with public debt file that information, after all. But there’s something else which gets triggered when you have more than 500 shareholders: you have to register your equity securities with the SEC. And at that point, your shares can be traded by anybody at all in the public over-the-counter markets, even if you haven’t had an IPO.

It’s conceivable that companies could continue to encrust their shares with various contractual restrictions which prevented shareholders from trading their shares in the OTC markets, even after those shares were formally registered with the SEC. But in practice, it’s almost impossible for companies to prevent OTC trading in their publicly-registered securities. And when a stock trades in the OTC markets, that trade is registered and printed in public. At that point, with a company’s stock being traded by anyone at all, at any time, at a public price, on the basis of public information filed with the SEC, the company is to all intents and purposes public already. So it might as well just make it official by having an IPO.

Now that Facebook has said that it passed the 500-shareholder limit this year, then, it’s pretty certain to go public in 2012. (Kara Swisher thinks it might be even earlier than that: I have a bet with her that it won’t happen before September 21 of this year. If it does, I need to go to San Francsico and buy her dinner, but if it’s still private at this point she needs to come to New York and take me out.)

SecondMarket actually has two platforms for trading private-company stock. The main one is Adam’s private company market, which is about two years old at this point, and has seen equity in 50 different growth stocks change hands. It’s pretty much restricted to growth stocks: none of those 50 companies has ever paid a dividend, and they’re overwhelmingly in the technology space.

For other companies, SecondMarket has set up a much more nascent market, which kicked off in January with those trades in Pimco stock. It’s also designed to help trade stock in partnerships (like McKinsey, say), or maybe even large, established private companies like Mars or Cargill. But mostly it seems that SecondMarket has its eyes on companies like Pimco which are subsidiaries of larger companies but which still use their own equity as a recruitment and compensation tool. Reddit is one company which might try to price stock on SecondMarket, as a way of helping it attract talent and grow while still remaining a part of Conde Nast.

Adam also helped answer my question of why SecondMarket is taking off now. Look at the three companies which really got this market started: Facebook, LinkedIn, and eHarmony. They’re all highly visible companies, with metrics that can be measured externally with quite a lot of specificity by companies like ITG Investment Research. It’s also much easier these days to find such companies’ articles of incorporation and the like online — and of course huge amounts of information about these firms is published by the fast-growing blogosphere. So while the amount of information that would-be investors have is surely lower than if there was a formal SEC-registered prospectus, the rise of the internet has made it much easier to do reasonably good diligence on how much a company might be worth. And that’s especially true when the company is young enough that its revenues don’t matter very much.

On top of that, webby companies like these are generally pretty capital-efficient: there’s very little risk that existing shareholders will be unpleasantly diluted by some big upcoming capital-raising round. It’s no coincidence that SecondMarket hasn’t seen trading in green-tech or biotech startups, which are much more capital-intensive.

And then there’s the big picture, which is simply that we’re seeing fewer IPOs of small companies, and that most companies when they do IPO are more like 8-10 years old rather than 3-4 years old. At that point, you’re likely to have had a reasonable amount of turnover in terms of employees, and early employees who have long since left the company are reasonably going to want a way to cash in their equity stakes. That demand for liquidity — along with long-term employees who have a lot of paper wealth but still live relatively frugally and who would like to monetize some of their stake — is what helped get SecondMarket’s equity business started.

Letting employees sell some of their vested stock doesn’t disalign incentives — quite the opposite, in many cases. After all, venture-capital owners of fast-growing tech startups are looking for high-risk home-runs and have diversified portfolios. Employees, by contrast, are always going to be more risk-averse, and letting them cash out in the growth phase can give them enough money to be willing to take the kind of risks their VC paymasters want to see.

It’s also worth clearing up some of the misconceptions in Dennis Berman’s column today on SecondMarket and SharesPost. For instance:

Many in Silicon Valley and Washington regard SharesPost and rival SecondMarket as small saviors of American capitalism. These markets give young companies and their employees new ways to raise capital or sell private stock without the arduous financial and legal disclosure of fully public companies.

This is partly true, but I’m pretty sure that neither SharesPost nor SecondMarket has ever let a company raise capital using their platform. I asked SecondMarket about this today, and in principle they’re open to exploring the idea in future, but for the time being they’re concentrating on simple transfers of shares, rather than the capital-raising issuance of new equity.

Berman continues:

SEC boss Mary Schapiro seems conflicted about these new markets’ purpose. The agency is investigating potential abuses in these secondary markets, including conflicts of interest and insider trading.

There’s no hyperlink here, so I have no idea what Berman thinks he’s talking about. It’s conceivable, I suppose, that he has an SEC source feeding him secret information about an internal SEC investigation that nobody else knows about. But if he did, one imagines he’d write a news story about that, rather than mentioning it in passing in a column which leads with the death of his grandmother 20 years ago. Certainly I’ve seen nothing to indicate that the SEC is investigating SharesPost or SecondMarket for potential abuses including insider trading; this seems to me to be both inflammatory and false.

After quoting Ben Horowitz as someone who is skeptical about such markets (but not mentioning that Horowitz spent $80 million buying shares of Twitter on SecondMarket in the secondary market), Berman comes out with this:

For a market to work best, investors need to be comfortable that they can trade at will.

This manages to completely miss the point of SecondMarket and SharesPost. They’re emphatically not trading vehicles: they’re designed to facilitate one-off transactions. In the two-year history of SecondMarket’s private-companies market, the company has seen maybe half a dozen instances of what you might call tertiary trades: someone who bought at one point and then sold later, once the price had gone up. SecondMarket gives an opportunity to invest in private equity, and private equity by its nature is illiquid. In fact, that’s why many investors like it: they want to capture the illiquidity premium, happy holding on to their stake for many years and knowing that they have an asset which isn’t highly correlated with public markets.

Going forwards, of course, SecondMarket would love it if the 500-shareholder restriction was relaxed. When the rule was introduced in 1964 it was pretty arbitrary, but it was set at a level which wasn’t particularly onerous: the 500-shareholder limit was very rarely triggered before a company went public. After all, in those days you could go public when you were still small; today, that’s much harder. Today, the 500-shareholder limit is a real constraint on how companies do business, how they compensate their employees, and how they structure themselves internally. Is there any good fundamental reason to change the way you incentivize and compensate employees just because you’re hiring lots of people? Of course not — but that’s the effect the rule has.

So while I worry about the public-policy effects of having fewer public companies, I also see no reason for the SEC to keep this rule at its anachronistic 1964 level. On the other hand, I think it might make sense for the SEC to regulate SharesPost and SecondMarket more explicitly than it does at present, rather than having them operate in the shadow of exemptions which were written long before they were founded. If the SEC set clear rules for how private exchanges like this could operate, then that might open the way to bring the rules for companies listing on public exchanges into the 21st Century.

Update: SecondMarket’s Mark Murphy emails to say that Horowitz’s secondary-market acquisition of Twitter shares did not take place through SecondMarket.

Clare Baldwin and Sarah Lynch are unambiguous: “As US regulators review rules on shares issued by private companies,” they write, “they must not make it too easy for hot Internet companies such as Facebook or Twitter to avoid the scrutiny that goes along with an initial public offering.”

They’re talking, of course, about the letter which SEC chairman Mary Schapiro sent to Darrell Issa on Wednesday. It’s a long and pretty boring document, and it’s certainly not as revolutionary as some of the press coverage would make you think. Jean Eaglesham, who broke the news without printing the letter, set the tone of the subsequent discussion by saying that the SEC review “could remake the way American start-ups raise capital,” “would upend the normal path for fledgling companies to raise funds,” and “could shut out many ordinary investors from one of the fastest-growing market sectors.”

But it’s hard to see anything in the letter which really supports Eaglesham’s reading. Mostly the letter is dry and legalistic, and in fact it takes pains to say that “the Commission seeks to minimize the costs of being a public company in the United States and provide a regulatory environment that encourages companies considering going public.” The part of the letter which talks about revisiting the 500-shareholder rule makes it clear that any change is overdue in any case, given how the rule isn’t having its intended effect:

All of this seems much more like a common-sense view of a rule which hasn’t really been updated since it was enacted in 1964, and much less like a revolutionary attempt to kill the IPO market by making it particularly attractive to stay private. Certainly there doesn’t seem to be any point in forcing companies to give out options, or phantom stock, or stock appreciation rights, or other such weird and wonderful inventions, just as a means of getting around a rule which has been around for half a century and is showing its age.

And it’s easy to overstate what exactly goes on in places like SecondMarket:

The SEC is wrestling with the needs of private companies to raise capital against the investing public’s need to make informed decisions.

The issue has jumped into the spotlight as Wall Street banks and electronic markets offer investors a chance to buy and actively trade stakes in hot Internet companies such as Facebook, Twitter, Groupon and Zynga before they go public.

Investors are indeed being offered the chance to buy stakes in companies like Facebook — although Facebook is sui generis and is much more of an outlier than it is typical. But as far as I know, no one is actively trading any of these properties. The auctions come up irregularly, they often require shareholders to hold on to their stock for a period of years, and the trading costs are very high — on the order of 5% per trade. Meanwhile, Goldman’s attempt to come up with a private exchange where shares could be actively traded has fizzled embarrassingly, and never attracted any hot internet companies.

As Jason Zweig says, there’s a good reason retail investors are barred from investing in private placements: they are very risky and dangerous things. But global high net worth individuals are increasingly interested in buying in to such placements, and the SEC has no real reason to stop them from doing so. I’m not a fan of this development. But that doesn’t mean I think the SEC should keep its rulebook in 1964, just because doing so might allow companies to prosper in private hands a bit longer.

Antony Currie wants a bit more clarity on why the Federal Reserve seems to be happy with Bank of America paying a dividend of 1 cent per quarter, but unhappy with a dividend of 5 cents per quarter. “It’s not clear,” he writes, “whether the Fed is worried about BofA’s core earnings falling short or about potential losses being higher than the bank projected, to pick a couple of possible concerns.”

My feeling is that the Fed’s logic wasn’t nearly that granular. There are basically three states that a bank can be in: it can pay no dividends at all; it can pay the minimum possible token dividend of 1 cent per quarter; or it can pay out a full and generous dividend. The Fed, in the wake of its latest stress tests, has determined that both Citigroup and Bank of America belong in the middle group. They can pay one cent a share, but no more — and in Citi’s case, they can only pay that much after doing a 1-for-10 reverse stock split and bringing the share price up above $40.

Paying a dividend is important from a symbolic perspective. It signals that the bank isn’t worried about insolvency, and it forces the bank to pay all dividends on preferred shares in full. If banks are paying dividends, that helps shore up confidence in the banking sector. If banks aren’t paying dividends, that keeps investors worried about what problems might lurk under the surface.

At the same time, the Fed has every interest in forcing banks to keep anything over one cent per share as precious capital, rather than sending it out to shareholders. The shareholders can’t do much with the money — not in this environment — while the system as a whole is clearly more robust the greater the amount of capital that banks manage to build up.

When Shira Ovide, then, characterizes the Fed’s stance towards BofA as “No Dividend for You,” she’s going too far. The Fed’s happy with BofA paying a dividend — indeed, astonishingly, BofA has been paying a dividend all along, with no objections from its top regulator. It just doesn’t want BofA paying out a dividend which is linked to profits. Not yet. For the time being, just like Citigroup, it’s being kept at that flat 1-cent-per-share level.

Update: I’ve heard a lot about mutual funds which are only allowed to invest in stocks which pay a dividend — sometimes with an explicit Berkshire Hathaway exception. Insofar as such funds exist, and I’m unclear on how prevalent they are, it makes a lot of sense to pay a de minimis dividend of one cent.

Cheyenne Hopkins, of American Banker, has a great coup today: she’s found the famous 27-page term sheet laying out exactly how the state attorneys general are trying to force mortgage servicers to “change a dysfunctional system”, in the words of Iowa AG Tom Miller. There’s a lot of material in here, and unfortunately I’m a bit pushed for time right now and can’t give it a full go-through until later tonight.

So have at it, and let me know what you find — do you think this will actually result in a lot more principal reductions, as outlined on pages 18-19? I do hope so, but that bit about being “reserved for further discussion” does give me pause. It’s certainly the part which would cause the greatest immediate harm to banks’ balance sheets — much more than any fine the AGs might come up with.

27 Page Settlement

There are basically two ways that the European crisis might end up resolving itself. Either the peripheral countries start defaulting, or else the eurozone becomes a fiscal union as well as monetary union. Both are politically unacceptable, of course. And George Soros, in a lucid column today, reckons that both might be in the cards:

The lack of a common treasury is now in the process of being remedied, first by a rescue package for Greece, then by creating a temporary emergency facility, and – the financial authorities being a little bit pregnant – eventually by establishing some permanent institution…

Structural changes may not be sufficient to provide the eurozone countries in need of rescue an escape route from their predicament. Additional measures, such as “haircuts” for holders of sovereign debt, may be needed.

Soros’s solution to the crisis involves recapitalizing the banks, and bringing them under a single European regulator. I like that idea—Europe’s banks have been far too leveraged for far too long, and Europe’s member states will always look forgivingly on their domestic institutions, setting off a regulatory race to the bottom. If a tough regulator can turn the banking systems in countries like Ireland and Spain into something strong and credible, that will help enormously in terms of reducing tail risk in the eurozone. And once that has happened, as Soros says, the banks should even be able to absorb a modest default from Greece or Portugal, and maybe even finance those countries’ recoveries.

When politics meets economics, politics always wins. Eurozone countries will only default when it’s in their political interest to do so; until then, some European institution or other will always be there, in extremis, to bail them out and provide the extra few billions needed to plug whatever budget gaps might be temporarily ineradicable. If you’re going to implement a fiscal union out of necessity that way, you might at least make a virtue of it by imposing a common set of banking standards at the same time.

The Fed’s swipe-fee proposals are out, and the market action in Visa and Mastercard — both of them are down more than 10 percent today — tells you everything you need to know. Basically, big card issuers won’t be able to charge more than 12 cents per transaction for debit-card purchases, and under one alternative their fees might be kept as low as 7 cents per transaction. That’s a massive reduction from the levels we’re seeing right now, which can range as high as 2 percent.

This is a victory for Dodd-Frank, a victory for consumers, and above all a victory for merchants over the financial-services industry. Assuming, that is, that the banks don’t find some way of killing, avoiding, or repealing it. Well done, Fed.

Jesse Eisinger has the story of CELF, which has some interesting implications. Essentially, Goldman Sachs took a bunch of leveraged loans it had lying around on its balance sheet, and bundled them into a CLO called CELF which it sold in July 2008.

The transaction was clearly profitable for Goldman — if it wasn’t, the bank wouldn’t have done it. And like all CLOs, the reason was that there was insatiable investor demand for triple-A-rated securities. As a result, by bundling up a bunch of loans and tranching them so that a triple-A-rated security fell out the other side, Goldman could make money: demand for AAA debt was much greater than demand for leveraged loans, so turning the latter into the former was profitable.

Then, this year, Goldman unwound the deal. It bought back those AAA-rated loans — I’m hearing at about 96 cents on the dollar — and bought a bunch of the equity in the deal as well, enough to bring its equity stake to something over 50%. With control of the CLO, Goldman then decided to liquidate it entirely, breaking it up into its constituent parts and selling off those loans in the secondary market.

This deal, too, was profitable for Goldman — for exactly the opposite reason that the CLO was. Today, there’s a lot of demand for high-yielding loans, or high-yielding anything, really. Meanwhile, there’s no appetite at all for structured products carrying AAA credit ratings which no one believes. So Goldman can make money by turning out-of-favor structured product into highly-desirable loans.

Eisinger’s point here is that Goldman reckons it can do this kind of thing — making money by structuring and unstructuring complex financial products — without falling foul of the Volcker Rule: at each step along the way, it can claim to be acting in its clients’ best interest. He’s right about that, and he’s also right that if the Volcker rule can’t stop this kind of activity, it’s likely to prove pretty toothless.

But we can also draw another lesson from this story: that securitization is still pretty dead. So long as investors prefer plain-vanilla loans to collateralized loan obligations, the securitization market — which bankers and politicians both have said is crucial to the efficient functioning of the economy — will remain moribund. Let’s hope they’re wrong, and that securitization isn’t all that necessary for a vibrant economy after all. Maybe it’s mainly just good in terms of making money for investment banks.

Clayton isn’t the only company doing due diligence on mortgages: another company doing the same thing is Allonhill. Whose CEO, Sue Allon, has a blog post up today explaining that there’s nothing to get excited about here:

In the run-up to the crisis, there was no rule that issuers had to perform due diligence at all. They obtained diligence for their own purposes, and when they did, no rule dictated that the results be disclosed to rating agencies and investors.

Allon goes on to say that “nobody – not investors, nor the SEC nor the rating agencies” was demanding that the due diligence reports be made public.

But this doesn’t make sense to me: why wouldn’t investors want to see the reports, if they knew they were being conducted?

And then there’s this:

The fact remains that investors still don’t have access to due diligence reports.

Still? How is that even possible? Isn’t the whole point of Section 15E(s)(4)(A) of the Exchange Act — introduced recently as part of Dodd-Frank — to force underwriters to give investors access to due diligence reports?

And as for the SEC not caring about this, I’d point you to to a letter that Clayton sent to the Financial Crisis Inquiry Commission. The idea was to distance itself from its former employees’ testimony, but check out this admission, towards the end:

Clayton began to review prospectuses in the summer and fall of 2007 in response to specific questions from regulators about whether Clayton’s due diligence results were set forth in MBS prospectuses.

Clearly, regulators have known about this issue for three years now; they’ve certainly known about it for long enough to insert Section 15E(s)(4)(A) of the Exchange Act into the Dodd-Frank bill.

So while Allon is right that there might not have been a specific rule requiring disclosure of the diligence results, there were still general rules requiring that underwriters disclose all relevant information when they sold mortgage bonds — or any other kind of security — to investors. That’s where the huge potential liability lies.

Update: Patrick Rucker of Reuters was all over this back in July 2007:

Investment banks that bundle and sell home mortgages often commissioned reports showing growing risks in subprime loans to less creditworthy borrowers but did not pass much of the information to credit rating agencies or investors, Wall Street sources said…

“If all the information about these investments was properly disclosed, our client would have made different decisions…and, specifically, not bought these investments,” said Dale Ledbetter, a Florida attorney suing Credit Suisse.

It’s weirdly depressing watching everybody scramble around trying to work out what on earth the kindasorta appointment of Elizabeth Warren to create the Consumer Financial Protection Bureau actually means. As Ryan Chittum notes, the WSJ certainly can’t make up its mind: David Weidner says that Warren is being sidelined and that “someone else will make the final decisions”; the paper’s news story, by contrast, says that she will have broad powers.

She will recruit staff for the agency, set the policy mission and serve as the recognizable public face for a new agency the administration wants to promote.

The big outstanding question is whether the White House intends to nominate Warren to lead the CFPB at some point in the future, before Obama’s first term is out. Jim Pethokoukis explains today that she’s probably here to stay:

There is an old management rule: Never hire someone you can’t fire. Obama violated this rule by picking Hillary Clinton for secretary of state. And he just did it again.

But weirdly, in exactly the same post, Jim says “it now seems unlikely that either Warren or Michael Barr will end up running this new agency”. It’s very hard indeed to reconcile the two positions: once the director is named, Warren’s job disappears. So either Warren is fired, or else she becomes the director. I can’t see any other outcome.

Ezra Klein, too, is trying desperately to hold two contradictory thoughts at the same time: this appointment “in no way prevents a permanent nomination from occurring at some later date”, he says, while at the same time “there’s no way Senate Republicans will ever let her have the permanent spot”.

My feeling is that once Warren has had this job for a while, and proven that she isn’t the devil incarnate, it might be possible to ratify her in the director’s position on a permanent basis. I certainly hope that’s what ends up happening. Probably both she and the White House want to keep their options open for the time being. But the communication around all this has been very messy, and there’s no sign that anything is going to get cleared up any time soon.

With a full news cycle now having been and gone since the Basel III accord was announced, a few things have come into more focus.

First, there will always be cynics and nay-sayers. Some of them are serious analysts who wanted a higher capital standard. But most are based on some variation on a simple, defeatist theme: “this doesn’t guarantee that there won’t be another crisis, and banks are still able to engage in dangerous behavior, therefore this is useless”. All I can say is that I’m very glad that the world’s central bankers didn’t feel that way and instead worked long and hard to try to put together a new set of standards which really will reduce systemic risk and strengthen the international banking system.

Of course, banking crises are always possible. But anything which reduces their likelihood is a good thing and Basel III reduces the likelihood of a banking crisis much more than all of Dodd-Frank put together.

Which brings me to Robert Peston, who’s upset at the media for not covering Basel more thoroughly. I’m sympathetic: I’m one of the few financial commentators in the mainstream media who, like Peston, has been banging on about this for a while, returning to the subject on a regular basis. And certainly, compared to Dodd-Frank, Basel III has received almost no press at all. But I part ways with Peston here:

There’s been little populist debate about how much capital and liquidity banks ought to hold for our own welfare. We’ve been presented with a fait accompli.

And most would argue that the media hasn’t exactly done a brilliant job in shining a light even on that fait accompli.

You might also ask where our [elected representatives] have been while unelected central bankers and regulators have trampled on territory that they would surely regard as their own, viz the fundamental laws that affect how [our] banks conduct their affairs.

So if you felt there had been something of a democratic failure here, you might have a point.

The way I see it, the Basel committees did a masterful job of depoliticizing the process as much as possible. The agreement is a win for Treasury, but Treasury was clever in not presenting it as such, because a large number of Republicans will automatically oppose anything that Treasury thinks is a good idea. The functionaries in Basel were generally mid-level central bankers, staying out of the spotlight as much as possible and putting together the best deal they could come up with. If politicians and the media had got involved, that might have made the process more democratic, but it would also have made it much more chaotic and quite possibly would have derailed any chance of an agreement at all.

The fact is that democracy simply isn’t the best possible way to construct a coherent regulatory regime for cross-border financial institutions. And the general public has every right not to feel the need to understand the difference between core Tier 1 and Tier 2 capital, or the finer points of how bank assets should be risk-weighted. This is something which central bankers, as a rule, know how to do — and the great news about Basel III was that they were given the freedom to go ahead and do it, while the power of the banking lobby was temporarily muted and in a period when anybody espousing a laissez-faire approach would automatically get laughed out of the room.

The main thing to take away from the Basel III announcement is that banks now need a lot more equity then they ever did in the past. It’s a little bit of a rhetorical stretch to say that the requirement for core equity has gone up from 2 percent to 7 percent, but it’s narrowly true all the same, even if the 2 percent requirement was never a central part of Basel 2 in anything like the way in which the 7 percent is the very heart of Basel III. And although the 7 percent requirement isn’t formally in effect, you can be sure that every bank in the world now feels the need to meet it. In fact, Credit Suisse said in a research note today that 8 percent is now the market standard for banks to be considered adequately capitalized.

Under previous administrations, financial regulations were quietly loosened, with disastrous results: think of the way that the SEC allowed almost unlimited leverage at investment banks in 2004, for instance. This time around, financial regulations are being quietly tightened. That’s a good thing and should definitely count as a signal achievement of the Obama administration. Even if the president himself isn’t going to make a major television address to trumpet it.

John Carney today writes about what he calls “the deeper problem” behind the Basel III negotiations: “how regulators can assess capital requirements without a functioning market process”.

Ideally, he says, “we wouldn’t have regulatory capital requirements at all”, and banks would voluntarily raise their capital levels because doing so would decrease their funding costs. But in an age of moral hazard and government guarantees, that doesn’t work.

But underlying all of this is the idea that there’s an art to setting an optimal capitalization ratio, so that it’s not too high and not too low. My feeling, by contrast, is that left to their own devices banks will always have too little equity and too much debt, for the reasons that Carney glosses and also just because they tend to trust each other too much, believing that in extremis they can always exit most of any given interbank position overnight.

Certainly I haven’t seen any correlation between leverage and profitability when it comes to the world’s banks. The most profitable bank I’ve ever covered on a regular basis is Brazil’s Banco Itaú, and it tends to have pretty conservative leverage. Meanwhile, Europe is full of extremely highly-levered banks which make relatively modest profits.

It seems to me, then, that excess banking-system leverage is something which happens in mature markets when the normal engines of bank profitability, such as loan growth, start running dry. In Carney’s ideal unregulated market, banks would start off with quite high capital ratios when economies are young and growing fast, and then slash that equity in a desperate attempt to preserve return on equity as their economies start to mature and growth slows down.

And while the emerging markets are no strangers to banking crises, the fact is that the most dangerous such crises are always the ones which take place in large, mature economies.

That’s where regulators — by which I mean the Bank for International Settlements, in Basel — have to step in, by forcing all countries to adopt a bare minimum capital requirement which will protect the system in two main ways: it will make bank failures less likely and less frequent, and it will improve the ability of the rest of the system to withstand any bank failure which does still occur.

Within reason, and so long as the requirement is imposed globally, there’s no reason that it can’t be very strict indeed; the noises coming out of Basel are a very good start. There’s very little downside to tougher capital requirements, and the people who complain about them most likely are probably just those who fear that their bonuses are going to fall. But that’s a feature, not a bug.

What does The Fiscal Times, the online newspaper founded by Pete Peterson, have against Elizabeth Warren?

On Friday, it ran a peculiar piece by Eric Pianin:

Warren’s critics say that her aggressive advocacy and stinging rhetoric make her the wrong choice to head a new agency that will have to mediate between conflicting industry and consumer advocacy interests as it writes and enforces a raft of new regulations.

This just isn’t true: the CFPB does not have to mediate between industry and consumer interests. The whole point of the CFPB is that it exists only to serve consumers. The Food and Drug Administration doesn’t look to balance the needs of consumers with those of pharmaceutical companies; similarly, the CFPB will simply set standards which big banks will have to meet. There are lots of financial regulators charged with ensuring the health of the banking sector; the CFPB the only one charged with looking after consumers. So anybody like Pianin who thinks that the CFPB ought to be at least in part captured by the banks is fundamentally missing its raison d’etre.

Then, today, the Fiscal Times followed up with another piece, by John Berry, saying that she doesn’t have “the balanced judgment needed to direct the new Consumer Financial Protection Agency within the Federal Reserve”. (It’s Bureau, not Agency, but never mind.) Again, it’s not the CFPB’s job to be balanced: it’s the CFPB’s job to protect consumers. But that’s not the real weakness of the column, which zeroes in on one of the reports that Warren released as head of the Congressional Oversight Panel. Warren was critical of Treasury’s actions in the AIG bailout, and Berry says that just isn’t fair:

Warren and the panel simply ignored reality in asserting that the government “failed to exhaust all options” before risking taxpayer money in the rescue…

What might have been the cost to the financial system and the economy if the government had held off hoping for the best as rating agencies speedily lowered AIG’s credit rating — triggering new demands for payments under the credit default swap contracts — and some creditor had forced AIG into bankruptcy? A partial answer can be found on the New York Federal Reserve Bank’s website. The report speculates in detail whether the many AIG insurance subsidiaries might have been able to survive a bankruptcy by their parent. The conclusion was that nobody could be sure — and if worse came to worse perhaps the government could help pay policyholders claims!

“In the ordinary course of business, the costs of an AIG failure would have been borne by its shareholders and its creditors,” Warren said. “But the government instead shifted those costs in full to taxpayers. This meant we rescued highly sophisticated investors who voluntarily accepted grave risks.”

That sort of language is misleading and only reinforces the views that the government wasted taxpayer money to save the fat cats. It’s misleading, first, because AIG shareholders were virtually wiped out. Second, much of the government’s assistance has been repaid and there is a good chance that within two or three years it all will be. Third, the true cost of an AIG failure — with its disastrous impact on the financial system — would have been borne by the additional millions of Americans who would have lost jobs and income during the even deeper recession that would have occurred.

This is wrongheaded on many levels. For one thing, it’s simply true that the government failed to exhaust other options before bailing out AIG, which got rescued by the government pretty much immediately after the government found out it was in trouble.

Berry also fails to link to the Fed report in question, linking instead just to the New York Fed’s homepage. Not helpful. But the fact is that, yes, if AIG’s shareholders and creditors were wiped out, then policyholders might, ultimately, have to get rescued by the government. That’s as it should be: insurance policyholders, like small bank depositors, should be protected from corporate failure. What’s clear is that bailing out small AIG policyholders makes a lot more sense, both politically and in terms of moral hazard, than bailing out enormous AIG creditors like Goldman Sachs, who ought to be able to look after themselves. I don’t know what exactly Berry is trying to convey with his exclamation mark, but taking the risk of bailing out AIG policyholders is clearly preferable to taking the certainty of bailing out AIG creditors.

Berry then finds an entirely unobjectionable quote from Warren, which he proceeds to label “misleading”, even when it is no such thing. Certainly it’s a lot easier to understand than Berry’s objections. Warren wants shareholders and creditors to share the pain; Berry says that hey, shareholders were “virtually” wiped out (which means they weren’t wiped out), without mentioning that creditors were paid off in full. The fact that the government may or may not end up being repaid is entirely a function of the degree to which it’s willing to accept a below-market interest rate on its loan, and in any case doesn’t change the fact that AIG’s creditors didn’t realize any of the downside risk that they were voluntarily taking on — and being paid to take on, with higher yields.

As for the idea that “additional millions of Americans would have lost jobs and income” had the government not intervened in AIG as it did, well, maybe. And maybe not. But it’s not the COP’s job to start disappearing down that particular rabbit hole: instead, its job is simply to look at whether TARP money was well spent. And two things seem pretty obvious to me: firstly, if the TARP money were leveraged through the addition of some funds from AIG creditors, the government would have got more bank for its buck. And secondly, the government never seriously considered doing that. It’s right and proper for Warren to point that out. And it’s certainly no disqualification when it comes to the CFPB job, no matter what weird jihad the editors of the Fiscal Times seem to be on.

Somehow I can’t imagine anybody doing this for Michael Barr.